Chapter Seven
TORRENS AND THE
TERMS OF TRADE ARGUMENT
DESPITE SHARING with David Ricardo the credit for developing the concept
of comparative advantage, Robert Torrens remains a relatively neglected
member of the classical school of economists. A cogent and forceful advocate
for free trade, Torrens also developed the most generally valid argument
for tariffs. He described conditions under which a tariff could benefit
a country by making the ratio at which it exchanged its products with the
rest of the world—the terms of trade, or the purchasing power of a country’s
exports in terms of the imports it can procure—more advantageous.
His strident and controversial criticism of unilateral free trade and advocacy
of reciprocity in the 1840s triggered a sharp debate among economists.
To argue against free trade was heresy in the minds of most economists
of the day, and in crossing those bounds Torrens became a pariah for
almost a century.1
But the terms of trade argument for protection is the
hardest to refute on theoretical grounds and remains the most durable and
important exception to free trade ever conceived.
⅐ ⅐ ⅐
Torrens’s early forays into economics were decidedly in favor of free trade.
In his 1808 tract The Economists Refuted, he introduced the term “territorial
division of labour” in rejecting the physiocratic notion that agriculture
alone, and not international trade, contributes to wealth. In 1815, as
discussed in chapter 6, he attacked protection to agriculture, stating that
England’s superiority in manufacturing was so great that it could import
corn with advantage even if its own land was more productive than land in
other countries. By this statement Torrens clearly anticipated the concept
of comparative advantage as expounded by Ricardo in his Principles of
Political Economy. Torrens also spoke out strongly in favor of free trade
and dismissed any arguments for reciprocity. To the frequent contention
1
The original Palgrave Dictionary of Economics dismissed Torrens’s work as “devoid of
permanent merit.” Decades later the New Palgrave said that Torrens, “if not in the top rank of
the classical economists, or in the class for example of Ricardo, Senior, or John Stuart Mill,
certainly was of the second rank and was the equal of, or even above, James Mill and McCulloch
in terms of originality, theoretical reasoning, and range of economic topics that he considered.”
See R.H.I. Palgrave (1913, 3: 550) and B. A. Corry (1987, 4: 659). For a masterful
overview of Torrens’s work, see Lionel Robbins (1958), especially chapter 7.
CHAPTER SEVEN102
that it is “highly inexpedient in any one country to abandon the restrictive
system [of import protection] while her neighbours continued to enforce
it,” Torrens (1821, 268ff) responded that “nothing can be more erroneous
or absurd.” A “mistaken policy on the part of France could furnish no conceivable
reason why England should imitate the absurd example,” he
wrote, adding that foreign protection did not force a free trade country to
pay any financial cost or tribute, something he would explicitly contend in
later work.
While Torrens and the classical economists were united in believing that
the free exchange of goods between countries was mutually beneficial, they
lacked insight into what determined the ratio at which goods would be
exchanged between countries. Early expositions of comparative costs examples
presumed a ratio of exchange exactly between the autarky cost ratios,
allowing both countries to share equally the gains from exchange.2
As
Torrens (1821, 260) put it, “The advantages of foreign trade are reciprocal,
and equally divided between nations carrying it on.” But the desirability of
sacrificing a smaller rather than a larger bundle of goods through exports in
exchange for a given quantity of imports (implying a high price of exports
relative to imports) was also clearly recognized, even if there was little
inkling about precisely how the terms of trade were established. Around
1820, Ricardo (1951, 2: 146) wrote that “it is undoubtedly true that if a
country is to pay a certain money price for foreign necessaries and conveniences,
it is for its interest to sell the commodities at a higher, rather than
at a lower price; it is desirable that for a given quantity of its own commodity,
it should obtain a large rather than a small quantity of foreign commodities
in return, but in what way a nation can so regulate its affairs as to
accomplish this by any means which it is in its power to adopt, I am totally
at a loss to conceive.”3
Despite the only rudimentary understanding of the determinants of the
terms of trade, Torrens gradually came to discover that a country could
shift the terms of trade in its favor by imposing a tariff. He used this theory
to argue that tariffs should not be reduced unilaterally, as this would adversely
affect the terms of trade, but in conjunction with other countries
acting similarly under a policy of reciprocity. The groundwork for Torrens’s
theory was developed in a series of letters to the Bolton Chronicle in
2
On early errors in determining how countries divided the gains from trade, see William
Thweatt (1987).
3
Ricardo (1951, 4: 71) staunchly supported free trade on a unilateral basis: “If foreign
nations are not sufficiently enlightened to adopt this liberal system, and should continue their
prohibitions and excessive duties on the importation of our commodities and manufactures, let
England set them a good example by benefiting herself; and instead of meeting their prohibitions
by similar exclusions, let her get rid, as soon as she can, of every vestige of so absurd and
hurtful a policy.”
TORRENS AND THE TERMS OF TRADE ARGUMENT 103
1832 as part of his effort to get elected to Parliament.4
Drawing on earlier
ideas of Ricardo and Nassau Senior regarding the international distribution
of precious metals, Torrens argued that tariffs could affect the movement
of precious metals across countries. In particular, a country imposing a
tariff would initially obtain a trade surplus, draw to itself a greater proportion
of the world’s precious metals, and thereby raise domestic prices,
wages, and profits, and increase the purchasing power of its labor in terms
of gold.
Holding his doctrines as immediately applicable to British circumstances,
Torrens (1833, 6) maintained that the prosperity of the country
depended on a trade policy based not on free trade, but on reciprocity. The
guiding principle of commercial policy should be “to lower the duties of
customs upon the importation of goods produced in countries which consent
to receive British goods upon terms equally favourable, and to prohibit,
or to lay heavy duties upon, the importation of all goods, not consisting
of first necessaries, produced in countries which prohibit, or lay
heavy duties upon, British goods.” Torrens accused the British government
of departing from these principles, thereby reducing the price of British
goods in foreign markets and undermining the country’s superiority in
manufacturing.
Torrens’s initial, incomplete formulation neglected to stress the gain
from improved terms of trade (or the international purchasing power of a
country’s exports) only to emphasize the deflationary consequences of unilateral
free trade on domestic prices. Yet his heresy was evident and Torrens’s
ideas met broad resistance. Perronet Thompson (1833a) failed to
understand how Torrens could argue that the nation as a whole could be
worse off as the result of the free and profitable private trade of merchants.
He further maintained that the export of specie was equivalent to the export
of any other profitable commodity. Torrens (1833, 58) dismissed Thompson
as having “no conception of the real question at issue.”5
J. L. Mallet’s
diary entry gives an indication of the suspicion and hostility with which
Torrens’s views were received in a Political Economy Club meeting in
1835: “The first question discussed was a question of Torrens, which was
unanimously voted to turn upon an impossible case. He claimed the right
to discuss any abstract proposition with a view to the establishing of principle,
but it was over-ruled in the present case which did not go to establish
but to disturb a principle, that of Free Trade upon grounds altogether hypothetical”
(Political Economy Club [1921, 270]).
4
These letters were collected and republished in Torrens (1833).
5
The meek reply is in Thompson (1933b). This exchange took a nasty turn. Torrens (1833,
57) called Thompson’s work “correct, where not original, and where original, not correct,” to
which Thompson (1833b, 423) excoriated Torrens’s “dishonest and in fact legally punishable
action” of attacking his work in that way!
CHAPTER SEVEN104
Torrens developed his views considerably more in a series of pamphlets
addressed to leading political figures during the tariff debates of the early
1840s and later collected in a book entitled The Budget: On Commercial
and Colonial Policy, published in 1844. Torrens became the leading exponent
of the view that a unilateral tariff reduction would be detrimental to
Britain’s national welfare. His analysis hinged on two Ricardian concepts.
First, international demand, and not costs of production alone, plays a role
in determining the terms of trade.6
Second, commercial policies affect the
international distribution of precious metals through the price-specie-flow
mechanism.
From these precepts, Torrens (1844, 28) argued that “when any particular
country imposes import duties upon the productions of other countries,
while those other countries continue to receive her products duty free, then
such particular country draws to herself a larger proportion of the precious
metals, maintains a higher range of general prices than her neighbours, and
obtains, in exchange for the produce of a given quantity of her labour, the
produce of a greater quantity of foreign labour.” This last statement, regarding
the quantity of goods a country’s labor could procure on the world
market, emphasized the efficiency of trade restrictions in possibly procuring
a large quantity of goods. The neighboring countries could recover
these precious metals, he wrote, by retaliatory tariffs that would restore the
previous exchange ratio.
Torrens then introduced a numerical example of tariffs and trade between
Cuba (representing the rest of the world) and Britain to illustrate
the proposition. If Cuba imposes tariffs from a situation of perfectly free
trade, Britain will initially find itself importing the same value of goods
from Cuba but exporting less. The concomitant trade imbalance will be
financed by a flow of specie from Britain to Cuba, thereby reducing British
prices and raising Cuban prices. The volume of trade would also adjust
to ensure balanced trade, with the volume of British exports becoming
larger and the volume of Cuban exports smaller. In the end, a greater
amount of British exports would be exchanged for a smaller amount of
imports from Cuba, an inferior ratio of exchange from Britain’s perspective.
While Torrens’s numerical example was produced under particular
assumptions, such as constant nominal outlays on Cuban products by Britain
(implying unit elastic demand), his proposition was later shown to be
more general in nature. Torrens (1844, 36–37) concluded that his example
proved that the “ultimate incidence of the import duty imposed upon Brit-
6
As Ricardo ([1817] 1951, 1: 133) put it, “The same rule which regulates the relative value
of commodities in one country, does not regulate the relative value of the commodities exchanged
between two or more countries.” Montiford Longfield (1835, 99–101) introduced
demand more explicitly as a determinant of the terms of international exchange, but his contribution
was incomplete and failed to attract much notice.
TORRENS AND THE TERMS OF TRADE ARGUMENT 105
ish goods would be upon British producers. The wealth of England would
be decreased by the amount of the duty—the wealth of Cuba would be
increased by its amount.” Yet Torrens believed that this terms of trade
effect “would be the least portion of the evil inflicted upon England by the
change which has been described,” and instead the deflationary consequences
were paramount—with “national bankruptcy and revolution . . .
the probable result.”
Torrens’s policy recommendations sparked a controversy among economists
that even spilled over into parliamentary debates. He (1844, 47–48)
insisted that the following practical rules of commercial policy are “direct
and necessary corollaries” from the principles he had described:
First,—to adopt, with respect to all foreign powers, the principle of reciprocity.—Second,—To
lower the import duties upon the goods produced in
countries receiving British goods upon terms equally favourable.—Third,—
To impose high or prohibitive duties upon goods, the produce of countries
imposing high or prohibitive duties upon British goods.—Fourth,—To admit,
duty free, all raw materials employed in the processes of reproduction.
These rules could hardly constitute the commercial policy recommendations
of a cosmopolitan free trader. In fact, Torrens was acutely aware of
the distinction between national and world welfare, for two paragraphs
later he wrote that “unrestricted interchange of commodities between different
countries, would increase the wealth of the world.” Implicit in this
statement is the recognition that the terms of trade improvement for Britain
would imply a corresponding terms of trade deterioration for other countries,
inflicting losses on others that exceeded Britain’s gains as the volume
of trade shrank. But as Britain’s national welfare was at stake, he scolded
the government for having “deprived the country of the advantages which
our manufacturing superiority would otherwise have secured” and having
“lowered the prices of British goods in foreign markets” (62). In addition,
reciprocity would “hold out to [foreign countries] a powerful inducement
to act upon the principles of reciprocal freedom” and perhaps lead to worldwide
free trade (65). In sum, Torrens believed that “reciprocity should be
the universal rule” and that “the sound principle of commercial policy is, to
oppose foreign tariffs by retaliatory duties, and to lower our import duties
in favour of those countries which may consent to trade with us on terms of
reciprocity” (50).
Many economists, outraged at what they thought were Torrens’s irresponsible
views, dismissed as irrelevant his whole analysis. As one anonymous
reviewer put it, Torrens’s analysis was “without even a shadow of
foundation.”7
Nassau Senior’s (1843) lengthy critique made him the most
7
“Colonel Torrens on Free Trade” (1843, 2).
CHAPTER SEVEN106
prominent (and the most eminent) opponent of Torrens. Unfortunately for
his cause, Senior’s essay in support of unilateral free trade was a weak and
desultory response.8
Despite this, the essay scored some telling points.
Senior first accused Torrens of rejuvenating the erroneous doctrines of
mercantilism. He (1843, 12, 14) then said that Torrens, while highlighting
the adverse terms-of-trade impact of reducing tariffs, ignored the costs entailed
by trade restraints:
Torrens assumes, first, that a country can exclude foreign commodities without
diminishing the efficiency of its own labour. . . . It is a great mistake to
suppose that a country which rejects the territorial division of labour, suffers
merely by the greater dearness of the commodities which it is forced to produce
instead of importing them. It incurs a further, and in many instances
greater, injury—in the general diminution of the efficiency of its own industry,
occasioned by the misdirection of capital and the diminished division of
labour.
Senior accepted but dismissed Torrens’s example of a tariff’s impact on
the terms of trade: “We believe this to be true; but we believe it to be one
of those barren truths from which no practical inferences can be drawn. . . .
In short, when he [Torrens] seriously urges us to act as if his hypothesis
represented the actual state of things, we utterly dissent from, and repudiate
his doctrine” (36–37). He also chided Torrens for assuming that Britain
was the innocent victim of foreign tariffs when its own trade barriers were
substantial as well.
Accurately noting that Senior was evasive in dealing with the main body
of his argument, Torrens (1844, 350–51) jumped on the admission that
Torrens’s doctrine was true: “Your utter dissent and repudiation are utterly
inconsistent with the facts and principles which you have yourself established
. . . the doctrine which you admit to be true.” Senior’s review was
also subject to a devastating attack by an anonymous author who laid out
Torrens’s ideas better than Torrens himself did.9
The author lambasted
Senior for accusing Torrens of rehabilitating mercantilism: movements of
precious metals were introduced only to restore trade to barter, the author
sharply reminded the reader, and tariffs brought national gain not from
acquiring metals per se but from changing the effective productivity of
British labor in acquiring goods through international trade. The author
easily demonstrated how supply and demand, and not costs of production
as Senior continued to maintain, regulated international values and how
8
This opinion was held even by those who shared Senior’s disdain for Torrens’s views.
“Senior’s article contains very many just remarks, but he did not take the trouble thoroughly
to understand T[orrens] before he sat down to answer him, therefore he is incomplete and
unsatisfactory,” opined S. J. Lloyd (Lord Overstone), a leading monetary theorist of the time.
See the letter to G. W. Norman (December 13, 1843) in Denis O’Brien (1971, 345).
9
“Reciprocal Free Trade” (1843).
TORRENS AND THE TERMS OF TRADE ARGUMENT 107
Torrens’s example could, in principle, be extended to many countries and
many commodities.
Herman Merivale (1842, 2: 305–11), one of the most incisive critics to
emerge, restated Torrens’s example of Cuba in purely barter terms not only
to focus on the essence of the tariff and terms of trade argument but to show
that the result was robust even when ignoring monetary adjustments. Merivale
then introduced a second country, Brazil, that could supply sugar to
Britain at a slightly greater cost than Cuba. If Cuba placed duties on imports
from Britain, thereby raising the relative price of its sugar, England
could simply switch its source of supply to “the next cheapest country producing
the same commodities as Cuba.” In all, Britain would be hurt only
in proportion to the gap between Cuba’s original price and Brazil’s price of
sugar, the trade of Cuba would be ruined, and Brazil would be the real
beneficiary of Cuba’s tariff. By allowing competition among Britain’s import
suppliers, Merivale demonstrated that Torrens exaggerated the impact
of foreign tariffs if not all other nations increased their tariffs.
Torrens (1844, 358) reluctantly conceded this point, admitting that if
Merivale’s “assumption bore any resemblance to actual circumstances, the
Cuba tariff could have a very slender effect in altering the terms of international
exchange to the disadvantage of England.” Torrens was left to assert
that his example of all foreign countries increasing their tariffs was more
appropriate.
George Warde Norman, in a lengthy publication written around 1845
and privately published in 1860, granted only that Torrens’s case was half
true. The burden of imposing retaliatory or reciprocity tariffs would also
fall in part on foreigners, but some of the burden would fall on Britain’s
producers and consumers. Even though the burden would probably be
borne equally by both countries, Norman (1860, 36) argued, the lower volume
of trade and diminution of the natural advantages of trade would ensure
that any gain would be “almost nugatory.” He also made the point that,
in practice, retaliation would never take place on the grounds established
by Torrens, who had excluded from the policy of reciprocity any tariffs on
raw materials, which, Norman pointed out, comprised the overwhelming
proportion of British imports.
Torrens’s analysis survived the onslaught of other theorists. James Anthony
Lawson (1843, 133–47) held that the distribution of precious metals
between countries was governed only by labor productivity in the export
sector and tried to come up with an arithmetic example of a Cuban tariff
that improved Britain’s terms of trade. Torrens (1844, lii–lvii) charged
that the first was a direct contradiction of Ricardian doctrine and showed,
along with an anonymous reviewer of Lawson’s work, that the arithmetic
example had a fatal inconsistency.10
Implicitly assuming that the terms of
10
“Professor Lawson’s Lectures on Political Economy” (1844).
CHAPTER SEVEN108
trade are fixed and given from the perspective of a country, J. R. McCulloch
(1849, 166) thought such tariffs would be “futile” as the burden on
import duties would always be on the country imposing such tariffs. But
McCulloch fully granted Torrens’s case for a country with a monopoly
power in the export good, in which case a country could affect the international
price of its exports.
This debate continued until John Stuart Mill weighed in with qualified
support for Torrens. Mill had anonymously reviewed one of Torrens’s
pamphlets in 1843 and shared his concern that foreign tariffs would accelerate
the decline of Britain’s position as workshop of the world. While not
directly discussing the terms-of-trade effects of tariffs, Mill (1843, 85–86)
called foreign tariffs “the real source of alarm” for stifling British exports
and potentially reducing the high wages commanded by British labor relative
to competitors. He urged Britain’s politicians to spread free trade to
other countries.
But Mill’s brilliant work on the determination of the terms of trade
clinched Torrens’s argument and essentially settled the debate among
economists. In 1844 in his Essays on Some Unsettled Questions of Political
Economy, Mill published “Of the Laws of Interchange between Nations;
and the Distribution of the Gains of Commerce among the Countries of the
Commercial World.” This essay, originally written in 1829–30 according
to Mill, described how world supply and demand determine the terms of
trade between countries. In his preface to the collection of essays, Mill
(1844, v–vi) wrote that they had been published “under the impression that
the controversies excited by Colonel Torrens’s Budget have again called
the attention of political economists to the discussion of the abstract science.
. . . It will be seen that opinions identical in principle to those promulgated
by Colonel Torrens (there would probably be considerable difference
as to the extent of their practical application) have been held by the writer
for more than fifteen years.”
“Of the Laws of Interchange between Nations” is the famous essay that
set out the theory of reciprocal demand as the determinant of the equilibrium
terms of trade. And it was here that Mill (1844, 21) questioned
“whether any country, by its own legislative policy, can engross to itself a
larger share of the benefits of foreign commerce than would fall to it in the
natural or spontaneous course of trade.” He answered affirmatively and
explained more clearly than Torrens the advantages of trade taxes if foreign
demand for a country’s exports is not perfectly elastic. In such a case, the
imposition of a tariff would reduce both import and export volume, with
the reduction in export supply driving up the price of those exports on
world markets. With the higher price, a given amount of exports could
acquire a greater amount of imports than previously was the case.
Mill cautioned that while import duties may be advantageous under such
TORRENS AND THE TERMS OF TRADE ARGUMENT 109
circumstances, “the determining circumstances are of a nature so imperfectly
ascertainable, that it must be almost impossible to decide with any
certainty, even after the tax has been imposed, whether we have been gainers
by it or losers” (25). Furthermore, because the tax could eliminate a
country’s trade if foreigners could buy from other sources, he argued that
“even on the most selfish principles, therefore, the benefits of such a tax is
always extremely precarious.”11
Mill also endorsed a qualified version of a reciprocity-based trade policy,
distinguishing between a protecting duty, which encourages a particular
branch of domestic industry by attracting labor and capital to its production,
and a revenue duty, levied on those goods not produced at home.
A “protecting duty can never be a cause of gain, but always and necessarily
of loss, to the country imposing it,” but Mill stated that, with revenue
duties,
considerations of reciprocity, which are quite unessential when the matter in
debate is a protecting duty, are of material importance when the repeal of
duties of this other description is discussed. A country cannot be expected to
renounce the power of taxing foreigners, unless foreigners will in return practise
towards itself the same forbearance. The only mode in which a country can
save itself from being a loser by the duties imposed by other countries on its
commodities, is to impose corresponding duties on theirs. (28–29)
Mill noted that a country could only improve its terms of trade at the
expense of other trading countries, and their losses would exceed the gains
of the tariff-imposing country. Therefore, “it is evidently the common interest
of all nations that each of them should abstain from every measure by
which the aggregate wealth of the commercial world would be diminished,
although of this smaller sum total it might thereby be enabled to attract to
itself a larger share.” But “until, by the common consent of nations, all
restrictions upon trade are done away, a nation cannot be required to abolish
those from which she derives a real advantage, without stipulating for
an equivalent” (31–32). Still, Mill believed that import duties would bring
harm to all countries, doubting that tariffs could be properly set to the
advantage of any. He observed with concern the severely protectionist
policies in France, the Netherlands, and the United States, arguing that
such policies, “though chiefly injurious to the countries imposing them,
have also been highly injurious to England” (38).
Thus Mill accepted (indeed originated, though Torrens popularized) the
theoretical point that a tariff can improve a country’s terms of trade. Mill
11
Mill set out his example in both barter and monetary terms. On the latter, Mill (1844,
40–41) noted what Torrens had stressed, that tariff reductions may have a deflationary effect,
but added that this gave “rise, as a general fall of prices always does, to an appearance, though
a temporary and fallacious one, of general distress.”
CHAPTER SEVEN110
stressed that such tariffs were a negative sum game for the world as a whole
(a point recognized but downplayed by Torrens, who was concerned about
national gains). As a result, Mill exercised great restraint in drawing specific
policy recommendations from the proposition. His (1843, 85) caveat
was that Torrens, “as is not unusual with him, seems to us to overstate the
importance and urgency of a portion of his doctrines in their application to
the immediate circumstances of the country.” That Torrens was correct in
theory was confirmed when the controversy prompted Mill to publish his
previously written essay on the subject. But as to the policy recommendations
that Torrens considered natural conclusions of his analysis, Mill hesitated
endorsing them and other economists rejected them entirely.
Torrens and Mill had developed a theory that consisted of two parts:
first, under certain circumstances a tariff reduction could lead to a deterioration
in the terms of trade (or, conversely, a tariff increase could improve
the terms of trade); second, a country undertaking such a tariff reduction
could conceivably suffer a net economic loss as a result. Mill and Torrens
demonstrated the first proposition conclusively. The second proposition
remained speculative: would the lower tariff bring about an adverse termsof-trade
effect sufficient to outweigh the gain from the expansion of trade
resulting from a greater international division of labor? Torrens and Mill
assumed that an improvement in the terms of trade by itself would necessarily
imply greater economic wealth. But this ignored the equally important
contribution of the volume of trade to the gains from trade, and hence
their cost-benefit analysis was inadequate. As F. Y. Edgeworth (1894, 40)
later noted, “Mill obscures the subject by taking as the measure of the gain
of trade the alteration in the rate of exchange between exports and imports
rather than the truer measure of advantage which the principles of consumers’
and producers’ rent afford”—or, in modern terms, consumer and
producer surplus as a measure of economic welfare.
It was not until the late nineteenth century that Edgeworth, an economist
and statistician at Oxford, demonstrated the validity of the second proposition
on more rigorous analytical grounds. Edgeworth employed a construction
called the offer curve, developed by Alfred Marshall in the early 1870s
to illustrate various combinations of export and import volume that a country
was willing to exchange with others, to represent graphically Mill’s
reciprocal demand theory.12
Edgeworth (1894, 433ff) ingeniously combined
these offer curves with a graphical representation of a country’s aggregate
economic welfare (through utility indifference curves, depicting
the country’s preferences across various goods). Edgeworth was thereby
able to sketch out a proof that, if the foreign (rest of the world) offer curve
12
Marshall privately distributed a manuscript describing these curves in 1879 but did not
initially apply this apparatus to commercial policy. He later reprinted them in part and discussed
tariff policy in Appendix J of Marshall (1923).
TORRENS AND THE TERMS OF TRADE ARGUMENT 111
was anything but perfectly elastic (in which case the terms of trade would
be fixed by the world market), there was the potential for tariffs to improve
the terms of trade and increase national welfare. The “optimal” tariff became
the term used to describe a tariff that exploited the terms of trade
precisely to maximize national economic welfare. Edgeworth also confirmed
the Mill-Torrens view that this gain arose entirely by imposing an
even greater loss on other countries. Edgeworth appears not to have recognized
the significance of his findings until later, but he secured for the terms
of trade argument the final clinching verdict. Any lingering doubts about
the theoretical possibility of achieving higher economic welfare under
these conditions through tariffs was eliminated.
Edgeworth’s work later convinced Alfred Marshall, the great Cambridge
University economist, to repudiate use of the analytical tools he himself
had developed. “In recent years, I have gradually gone away from the fundamental
hypothesis on which the curves are based,” Marshall (1925, 449)
wrote to a correspondent in 1904. “They lead to the result that a great part
of an import duty will probably fall on the export nation: and I have become
convinced that, though the reasons which the old free-traders gave
for the opinion that import duties are paid almost entirely by the consumer
are wrong, yet their result is pretty well true.” Despite Marshall’s concern,
his offer curve construction became a standard tool in the theoretical analysis
of tariffs. Edgeworth’s analysis was later revived and elaborated by
Nicholas Kaldor (1940) and others in the 1940s. This approach culminated
in the early 1950s with the derivation by Harry Johnson (1950–51) of a
precise mathematical formula for the “optimal” tariff based on the elasticity
of the foreign offer curve.
Aside from these advanced analytical deliberations, another debate concerning
Torrens’s and Mill’s theory focused on the closely related question
of tariff incidence—or “who pays the tariff?”—when a country possesses
market power in its export or import markets and does not take world prices
as given. Some classical economists, such as J. R. McCulloch (1849, 166)
as we have seen, implicitly assumed that a country could not influence the
prices of its imports as determined by world market, and therefore concluded
that domestic consumers bore the full burden of the tariff. Under
this scenario, the idea that tariff revenue could be extracted from foreign
suppliers “is wholly visionary, and that duties on imports are always paid
by the importers and never by the exporters” Advocates of tariffs, of
course, took the other extreme position and asserted that the burden of
import tariffs could be shifted entirely onto foreigners through lower import
prices.
Mill, appropriately, took a middle path. As a result of his theory of reciprocal
demand, Mill (1844, 27) pointed out, “it may, therefore, be laid down
as a principle, that a tax on imported commodities, when it really operates
CHAPTER SEVEN112
as a tax, and not as a prohibition either total or partial, almost always falls
in part upon the foreigners who consume our goods; and that this is a mode
in which a nation may appropriate to itself, at the expense of foreigners, a
larger share than would otherwise belong to it of the increase in the general
productiveness of the labour and capital of the world, which results from
the interchange of commodities among nations.”
But the state of knowledge about the question of tariff incidence remained
uncertain through most of the nineteenth century. Henry Sidgwick
(1883, 492–93) argued that “there is no theoretical means of determining”
the impact of a tariff on domestic consumers or producers, but “unless
foreign products are completely excluded by import duties, such duties will
partly have the effect of levying a tribute on foreign producers, the amount
and duration of which may in certain cases be considerable.” This arises
either because the foreign costs of production (and hence its price) will fall
as its export volume falls, or because profits could be extracted from foreign
monopolists or cartels. On the export side, Edgeworth (1894, 42–43)
reiterated Mill’s argument about how export restraints could be advantageous
in raising export prices (if foreign demand for a country’s goods was
somewhat inelastic), noting that “it is often stated with the unnecessary
limitation that the home country must have an absolute monopoly of the
exporting article,” whereas “that she should furnish a considerable portion
of the total supply might suffice.” It was later pointed out that if domestic
producers do not act as perfect competitors in the export market but recognize
the market power that they collectively possess, these producers will
collude to restrict their exports and hence mimic the optimal export tax,
obviating the need for government intervention.
Yet outlining the possibility of such an outcome was quite different from
actually proposing tariffs for this purpose. Joseph Shield Nicholson (1891,
465) summed up the view of many economists at the end of the nineteenth
century in writing that
taxing the foreigner is very like “shearing the wolf.” It is quite true that theoretically
under certain conditions one nation might obtain from other nations,
either by export or by import duties, a considerable part of its revenue, but it
is equally true that these conditions are extremely unlikely to arise; and even
if they did arise, it is still more unlikely that the wisdom of statesmen would be
equal to the task of taking advantage of them. It is important to observe that
theoretical exceptions may be admitted whilst the practical application is
denied, for no greater harm has been done to the spread of “Free Trade principles”
in the broad sense of the terms than by the attempt to reduce them to a
fictitious simplicity. To assert that every import-duty must necessarily fall on
the home consumer is as false as to assert that every export-duty must necessarily
fall on the foreign consumer; it is equally untrue to say that necessarily
the import-duties fall on the foreign producer and the export-duties on the
TORRENS AND THE TERMS OF TRADE ARGUMENT 113
home producer. As a matter of fact the incidence of export and import duties,
especially when the indirect effects are considered, is the most complicated
and difficult problems in economics.13
The “complicated and difficult problem” of determining tariff incidence
and whether the tariff burden could be shifted onto foreigners soon gave
way to an analytical breakthrough. Using Marshall’s supply and demand
schedules to represent the market for an imported good in partial equilibrium,
Charles F. Bickerdike (1906, 529ff) raised the question of whether “a
country, by means of taxes, can get more favourable terms of exchange
with foreigners in such a way as to leave a net advantage, after allowing for
the disadvantages involved in turning production from its ‘natural’
course.” He answered affirmatively: “In pure theory advantage is always
possible in normal circumstances from either import or export taxation
when the taxes are small enough.” Provided only that the foreign export
supply curve is upward sloping, some of the revenue generated by a tariff
is extracted from the producer surplus of foreign suppliers. Furthermore,
this is “a general possibility of advantage not confined to exceptional circumstances.”
Bickerdike demonstrated with the simple Marshallian geometry
that, for small or “incipient” taxes, a net gain results: the higher domestic
price paid by consumers is largely a transfer to the government treasury,
but the small deadweight loss of consumer surplus is exceeded by the gain
from lower foreign prices over the entire volume of imports (and collected
as tariff revenue) at the expense of foreign producers.
Bickerdike later extended these findings to derive a mathematical formula
for the optimal tax based on export and import supply and demand
elasticities. Under this formula, he (1907, 101) noted that “rather strong
assumptions have to be made as to the elasticity of foreign supply and
demand if the rate of the tax affording maximum advantage is to come
below 10 per cent.” In evaluating this theory, Edgeworth (1908, 392)
praised Bickerdike for his having “accomplished a wonderful feat” of saying
“something new about protection” and reinforced the point that Bickerdike
was correct as a matter of theory. But Edgeworth was deeply skeptical
about the practical application of the finding. Conceding that Bickerdike’s
result appeared to be quite general and only required information about
supply and demand elasticities, Edgeworth (1908, 554) remarked that the
theory seemed
to justify the imposition of small customs duties, say from 21⁄2 to 5 per cent,
on a great number of articles. The objection that industry is thereby directed
into less advantageous channels is not admissible; for by the theory the disad-
13
Nicholson (1901, 306) later wrote that “certain exceptional conditions under which it is
theoretically possible by the judicious manipulation of duties to extract a certain amount of
revenue from the foreigner” although “practically they are of little importance.”
CHAPTER SEVEN114
vantage in the way of production is overbalanced by the gain accruing to the
Treasury. Abstracting the practical difficulties to which we are coming, on the
platform of pure theory the Free Trader must abandon his hectoring tone with
respect to the defence of a Protectionist tax on the ground that it is a little one.
But Edgeworth went on to mention “weighty objections” that gave the
theory “limited application.” Aside from the frictions that many small
taxes would entail in practice, the foremost obstacle was the threat of retaliation.
Bickerdike’s novel and ingenious sketch may imply a strong ability
of hitting the foreigner with taxes because it “may be practiced by a country
which has no special [monopoly] advantages” in trade, “but it equally increases
the power of the foreigner to hit back.” For these reasons, Edgeworth
(1908, 555–56) continued,
the direct use of the theory is likely to be small. But it is to be feared that its
abuse will be considerable. It affords to unscrupulous advocates of vulgar Protection
a peculiarly specious pretext for introducing the thin edge of the fiscal
wedge. Mr. Bickerdike may be compared to a scientist who, by a new analysis,
has discovered that strychnine may be administered in small doses with prospect
of advantage in one or two more cases than was previously known; the
result of this discovery may be to render the drug more easily procurable by
those whose intention, or at least whose practice, is not medicinal. . . . Let
us admire the skill of the analyst, but label the subject of his investigation
POISON.
Just as the foreign reciprocal demand approach had been resurrected in
the 1940s, the partial equilibrium “elasticities” approach to the optimal
tariff was also resurrected then by, among others, Richard Kahn (1947–48),
who supported Bickerdike’s contention that the optimal tariff could be substantial
based on what was believed about the magnitude of the elasticities.
Thus, although the terms of trade argument continued to undergo further
refinements, few developments have seriously undermined its standing as
a theoretically valid proposition. The most commonly proposed qualification
is that foreign retaliation might undo the positive terms of trade effect
of one country’s optimal tariff. Since a country could only improve its
terms of trade at the expense of other countries, an attempt to do so might
incite the other countries into responding in kind to preserve their own
position. And if all countries use tariffs in seeking to improve their terms
of trade, the result would simply be a contraction in the volume of trade
without anyone succeeding in their effort. One conceptual qualification to
this argument was provided by Harry Johnson’s (1953–54) finding that it
was at least possible that, even after retaliation, one of the countries could
still be better off than it would have been under free trade. Yet Johnson
showed a possibility, not a likelihood, and the threat of foreign retaliation
TORRENS AND THE TERMS OF TRADE ARGUMENT 115
has been an oft-invoked practical argument against the terms-of-trade motive
for trade intervention.14
The conclusion to be drawn from the terms of trade controversy is not
that free trade is undesirable, but that, under certain circumstances, unilateral
free trade is undesirable. Therefore, to avoid a situation in which countries
seek to gain at the expense of others by imposing optimal tariffs,
thereby diminishing the worldwide gains from trade, countries may wish to
have a commitment mechanism, an agreement, in which all agree to forgo
the use of tariffs for this purpose. In this context, contractual multilateral
free trade avoids some of the problems associated with countries seeking to
manipulate their terms of trade. And, of course, the cosmopolitan case for
free trade remains unaffected. As John Stuart Mill (1844, 44) put it, “If
international morality, therefore, were rightly understood and acted upon,
such taxes, as being contrary to the universal weal, would not exist.”
⅐ ⅐ ⅐
After a brief but intense debate, Torrens’s speculations that tariffs could
conceivably be beneficial in improving the terms of trade gradually become
orthodoxy under Mill, who demonstrated the soundness of these
speculations in terms of its underlying economic analysis. Although inadvisable
from a global perspective for shifting the gains from trade to one
country at the greater loss of others, few developments have detracted from
its validity as a theoretical proposition. Indeed, of all the economic arguments
against free trade, the terms of trade argument appears to be the most
robust and least subject to qualification or exception, and it remains the
most widely acknowledged and generally accepted restriction to free trade
admitted by economic theory.
14
Carlos Rodriguez (1974) showed that both countries would definitely be worse off if
retaliation took place by means of import quotas instead of import tariffs.
Chapter Eight
MILL AND THE
INFANT INDUSTRY ARGUMENT
JOHN STUART MILL, the preeminent figure in mid-nineteenth-century economics,
wrote the Principles of Political Economy (1848), which became
the standard economics treatise for several generations of students. Yet one
paragraph of Mill’s influential text inspired a lasting controversy and
earned him the scorn of many of his contemporaries. In a brief passage,
Mill gave his qualified endorsement to temporary protection for “infant
industries,” defined as industries that were not initially capable of surviving
in the face of import competition but with time and experience could
grow to compete successfully in world markets. Mill caused great consternation
among economists by sanctioning this argument for protection, although
he eventually (but quietly) recanted his endorsement of tariffs as the
means of supporting such industries. Despite its somewhat vague theoretical
formulation, the infant industry argument survived many criticisms and
continues to occupy an uneasy place in the theory of commercial policy.
⅐ ⅐ ⅐
The infant industry argument, which is perhaps the oldest and longest-lived
specific argument for protection, can be traced at least as far back as the
Elizabethan period. Precise statement of the doctrine, involving temporary
protection to establish a new industry, arises in the mercantilist period.
Viner (1937, 71) finds a passage from 1645 arguing that monopoly privileges
in a particular trade were no longer necessary because the domestic
firm, having matured, was no longer in its infancy. More common were
pleas for government support to assist fledgling manufacturers against foreign
competition. Andrew Yarranton (1677, 62), for example, advocated
that the linen and iron manufactures may be so encouraged here by a public
law, as that we may draw these trades solely to us, which now foreign nations
receive the benefit of, there ought in the first place to be a tax or customs at
least of four shillings in the pound put on all linen yarn, threads, tapes, and
twines for cordage that shall be imported into England . . . and this law to
continue and be for seven years. And by virtue of this tax or imposition, there
will be such advantage given to the linen manufacture in its infancy, that
thereby it will take deep rooting and get a good foundation.
MILL AND THE INFANT INDUSTRY ARGUMENT 117
William Wood (1718, 224–25) repeated verbatim the statement by
Theodore Jansssen (1713, 9) that “all wise nations are so fond of encouraging
manufactures in their infancy, that they not only burden foreign manufactures
of the like kind with high impositions, but often totally condemn
and prohibit the consumption of them.” Arthur Dobbs (1729, 2: 65ff) argued
similarly: “Upon the whole, premiums are only to be given to encourage
manufactures or other improvements in their infancy, to usher them
into the world, and to give an encouragement to begin a commerce abroad;
and if after their improvement they can’t push their own way, by being
wrought so cheap as to sell at par with others of the same kind, it is in vain
to force it.”
The infant industry case was a part, although by no means a pervasive
part, of the mercantilist desire to promote domestic employment and industry.
These few early statements adequately convey the main thrust of
the infant industry doctrine, that before new industries could compete successfully
against established foreign rivals, government assistance was
required to help them overcome certain start-up obstacles and grow to maturity.
The appealing and intuitive metaphor of an “infant” lured most eighteenth-century
economic writers into accepting the case for infant industry
protection without much serious questioning. Even Adam Smith’s teacher,
Francis Hutcheson (1753, 308), seemed to accept the doctrine when he
wrote “all mechanick arts, either simpler, or more elegant, should be encouraged,
lest our wealth be drained by our buying foreign manufactures.”
The infant industry argument was so widely accepted that writers made
their mark by pointing out qualifications to it. Josiah Tucker (1758, 50–51),
for example, cautioned that protection should be temporary or else the infant
industry may never mature:
It is also easy to see, that such infant manufactures, or raw materials, as promise
to become hereafter of general use and importance, ought to be reared and
nursed during the weakness and difficulties of their infant state, by public
encouragements and national premiums. But it doth by no means so clearly
appear, that this nursing and supporting should be continued forever. On the
contrary, it seems more natural to conclude, that after a reasonable course of
years, attempts ought to be made to wean this commercial child by gentle
degrees, and not to suffer it to contract a lazy habit of leaning continually on
the leading strings . . . that trade is not worth the having, which never can be
brought to support itself.
Others argued that the tariffs used to promote infant industries should
not be set too high. In Malachy Postlethwayt’s (1757, 2: 397) view:
A manufacture, even in its infancy, seems not to have any reason to fear foreign
competition, when the duties of entry are at 15 per cent; for the charges of
CHAPTER EIGHT118
carriage, commission, and others, will come to 4 or 5 per cent more. If 18 or
20 per cent, besides the foreign manufacturer’s profit, do not content the home
manufacturer; one may readily conclude, either that such home manufacture
wants to gain too much, or, that his undertaking is badly managed; or, in short,
that there are such obstacles in the way at home, which must be removed
before success can be expected.
On the other hand, James Steuart ([1767] 1966, 262–63) expounded the
infant industry argument with great enthusiasm and little qualification:
“The ruling principle, therefore, which ought to direct a statesman in promoting
and improving the infant trade of his people, is to encourage the
manufacturing of every branch of natural productions, by extending the
home-consumption of them; by excluding all competition with strangers;
by permitting the rise of profits, so far as to promote dexterity and emulation
in invention and improvement; . . . and, until it can be exported to
advantage, it may be exported with loss, at the expence of the public.”
Steuart had no concern that protection would produce slothfulness rather
than promote improvement, for “as long as the gates of a kingdom are kept
shut, and that no foreign communication is permitted, large profits do little
harm, and tend to promote dexterity and refinement.”
Although economic writers differed in the degree to which they qualified
their support for infant industry policies, one is hard pressed to find anyone
who actually disputed the basic argument prior to Adam Smith. It is a credit
to his intellectual independence that Smith opposed government support
for infant industries even though other Scottish philosophers (such as Lord
Kames) endorsed it. Perhaps in response to unqualified statements like
Steuart’s, Smith reacted so strongly against the infant industry doctrine
that, unlike his predecessors, he came close to denying that such protection
could ever be beneficial:
By means of such regulations, indeed, a particular manufacture may sometimes
be acquired sooner than it could have been otherwise, and after a certain
time may be made at home as cheap or cheaper than in the foreign country. But
though the industry of the society may be thus carried with advantage into a
particular channel sooner than it could have been otherwise, it will by no
means follow that the sum total, either of its industry, or of its revenue, can
ever be augmented by any such regulation. The industry of the society can
augment only in proportion as its capital augments, and its capital can augment
only in proportion to what can be gradually saved out of its revenue. But the
immediate effect of every such regulation is to diminish its revenue, and what
diminishes its revenue, is certainly not very likely to augment its capital faster
than it would have augmented of its own accord, had both capital and industry
been left to find out their natural employments. Though for want of such regulations
the society should never acquire the proposed manufacture, it would
MILL AND THE INFANT INDUSTRY ARGUMENT 119
not, upon that account, necessarily be the poorer in any one period of its duration.
In every period of its duration its whole capital and industry might still
have been employed, though upon different objects, in the manner that was
most advantageous at the time. In every period its revenue might have been the
greatest which its capital could afford, and both capital and revenue might
have been augmented with the greatest possible rapidity. [WN, IV.ii.13–14]
To Smith, the underlying cause of the foreign industry’s superiority was
irrelevant: “Whether the advantage which one country has over another, be
natural or acquired, is in this respect of no consequence. As long as the one
country has those advantages, and the other wants them, it will always be
more advantageous for the latter, rather to buy of the former than to make”
[WN, IV.ii.15]. Indeed, Smith was so deeply skeptical of the infant industry
argument for protection that he conceded virtually nothing to it. Just because
a country could acquire an industry by means of such protection did
not imply that it should do so, or that the country would be better off for
having done so. And even if a country could eventually produce that industry’s
good at a lower price than foreign producers, the policy still might be
disadvantageous: protection would distort resource allocation, reduce national
income, and thereby shrink the pool of investible savings available
for capital accumulation. Smith also implicitly stressed the intertemporal
balancing of the policy’s costs and benefits, that the short-run costs must be
offset by some distinct, long-run benefit, a point that was to be ignored for
decades. However, by taking a fairly static view of infant industries, Smith
was vulnerable to critics who would complain that he failed to deal with the
essentially dynamic issues involved.
Other classical economists followed Smith’s lead on the infant industry
argument, either treating it unfavorably or ignoring it altogether. JeanCharles-Léonard
Simonde de Sismondi (1815, 70) focused on the opportunity
costs of shifting by artificial means scarce resources into favored sectors
at the expense of other sectors: “It ought to be recollected that each
merchant knows his own business better than the government can do; that
the whole nation’s productive power is limited; that in a given time, it has
but a given number of hands, and a given quantity of capital; that by forcing
it to enter upon a kind of work which it did not previously execute, we
almost always at the same time force it to abandon a kind of work which it
did execute: whilst the most probable result of such a change is the abandonment
of a more lucrative manufacture for another which is less so, and
which personal interest had designedly overlooked.”1
1
See also Simonde de Sismondi ([1826] 1991, 327–42). This became an important theme
in the classical critique. “In the infancy of any such employment, it is only by actual wealth,
in the shape of additional capital, that any effectual assistance can be given to a new branch of
industry,” Jeremy Bentham (1843 [1821], 96) stated. “By removal of competition, increase
CHAPTER EIGHT120
Others were skeptical of the infant industry argument on the grounds that
protection would just create inefficient industries. J. R. McCulloch thought
it unlikely that the domestic industry could ever succeed in reducing its
price below the lowest import price, but according to D. P. O’Brien (1970,
221) was apparently inconsistent on this point. George Scrope (1833, 369)
believed that import prohibitions could “raise some faint imitation of a
foreign manufacture in a country unsuited for its production,” but that
“there is a waste of all the trouble and expense which the effort has cost. . . .
In the sickly and confined atmosphere of the legislative forcing-frame [industry]
loses its health and vigour, decays, and before long expires.” JeanBaptiste
Say (1834, 131) accepted Smith’s dictum in general, but then conceded
that cases could exist wherein “a new channel of industry may ruin
an unsupported speculator, though capable of yielding enormous profit,
when the labourers shall have acquired practice, and the novelty has once
been overcome.”
The debate over infant industries from the mercantilists through the classicals
(but prior to Mill’s statement) hinged on three key issues: whether
infant industry protection would (1) create new wealth and capital, or
merely divert it from other more profitable activities; (2) stimulate domestic
producers to acquire new technology and skills, or just stifled the incentive
for such efforts; and (3) generate long-term net benefits, or simply
foster costly industries that required ongoing government support. On the
first issue, the conceptual framework of Smith and Bentham was structured
in a way that emphasized resource constraints, whereas proponents (coming
from a different perspective) disputed or ignored that point. On the
second issue, the stimulating effect of infant industry protection envisioned
by Steuart (“promotes dexterity and emulation in invention and improvement”)
was contrast with the depressing effect envisioned by Scrope
(“loses its health and vigour, decays, . . .”). The third issue, the intertemporal
cost-benefit analysis, was a crucial but neglected aspect of the economic
case for infant industry protection.
Unfortunately, there was no agreement on how to determine which of
these perspectives was most appropriate. Indeed, economic analysis alone
was of little assistance in evaluating these issues: one could envision the
successful maturation of the infant, and yet one could also entertain the
possibility of protection breeding inefficiencies; a priori, neither outcome
could be dismissed. Thus, the debate amounted to the exchange of claims
and assertions about which effects were more likely. Indeed, for many demay
indeed be given to the rate of profit, if profit be the result of the newly directed labour: but
it is only by the employment of capital, which must necessarily be taken from other sources,
that this result can be obtained; the prohibition of existing rival establishments will not create
that capital.”
MILL AND THE INFANT INDUSTRY ARGUMENT 121
cades, the problem afflicting the infant industry argument was the lack of
a substantive economic structure behind it. Without such structure, economic
theory could not provide a satisfactory resolution to the debate over
whether government intervention was justified.
With some hedging, the classical economists broadly supported the view
that infant industry policies were not advisable. They based this verdict on
their observations about tariff policies in practice and on their view (following
Adam Smith) that policies of “preference or restraint” could not
improve upon the economic outcome that arose from a system of natural
liberty. But if Smith and his followers believed that their criticisms were
sufficient to undermine the infant industry argument, they were sorely mistaken.
A decidedly different view of the issue was taken elsewhere in the
world. Economic observers in America, Europe, and in other industrializing
countries of the day saw no reason for importing manufactured goods
from wealthy Britain when their own country seemed to have the skills and
resources necessary to produce such goods at home. Far from suffering any
inherent and immutable cost disadvantage, all their fledgling manufacturers
apparently lacked was the accumulated experience and expertise
required to produce such goods more efficiently. Three major figures—
Alexander Hamilton, John Rae, and Friedrich List—gave renewed force to
the infant industry argument even after Smith’s scathing treatment.
As the first United States Secretary of the Treasury, Hamilton penned the
famous “Report on Manufactures” in 1791. Hamilton objected to Smith’s
doctrine that, if left to itself, industry would automatically take the most
profitable course of development.2
Hamilton ([1791] 1966, 266–67) spoke
of “the strong influence of habit and the spirit of imitation—the fear of
want of success in untried enterprises—the intrinsic difficulties incident to
first essays toward a competition with those who have previously attained
to perfection in the business to be attempted—the bounties, premiums, and
other artificial encouragements, with which foreign nations second the exertions
of their own citizens in the branches, in which they are to be rivaled,”
all as obstacles to the establishment of new industries. Overcoming
these obstacles “may therefore require the incitement and patronage of
government.” Although Hamilton recognized that import restrictions
would increase domestic prices, “it is universally true, that the contrary is
the ultimate effect with every successful manufacture. . . . Being free from
the heavy charges, which attend the importation of foreign commodities, it
can be afforded, and accordingly seldom or never fails to be sold cheaper,
in process of time, than was the foreign article for which it is a substitute”
(286).
2
Hamilton drew quite extensively on the Wealth of Nations, even when he disagreed with
it. See E. G. Bourne (1894).
CHAPTER EIGHT122
Although Hamilton’s discussion of infant industries was more detailed
than any previous writer and his argument received widespread attention,
there is little that is fundamentally new in his analysis. But his study of
policy instruments is quite insightful for this period. Hamilton compared
the effects of four policies to promote domestic manufactures: protective
duties, prohibitions, export taxes on raw materials, and pecuniary bounties
(subsidies). For three reasons, Hamilton’s preferred method of intervention
was a subsidy: first, bounties have a “more immediate tendency to stimulate
and uphold new enterprises, increasing the chances of profit, and diminishing
the risks of loss, in the first attempts”; second, “bounties have
not like high protecting duties, a tendency to produce scarcity,” that is,
higher domestic prices; third, bounties also promote exports and thereby
extend the size of the market for domestic producers (299). Alternatively,
import duties raise revenue, but assist producers in the domestic market
alone with no direct effect on exports. Recognizing the fiscal constraints to
providing subsidies, Hamilton proposed the practical compromise of levying
import duties with the resulting revenue being used to finance bounties
on domestic production.
John Rae, a Scotsman who had migrated to Canada, provided a more
acute analysis of infant industries. Disputing the notion of a harmony between
the interests of an individual and the interests of society, Rae directly
attacked Smith’s claim that tariff protection would, by reducing national
income, reduce capital accumulation.3
But Rae framed his discussion of
infant industries more in terms of the advisability of government assistance
to the transfer of superior technologies from other countries. Rae (1834,
364) believed that the “general practical conclusion” about the desirability
of government intervention to facilitate technology transfer must be
granted. But, he added, the case “resolves itself into particulars, and the
investigations of the political economist, would seem to be confined to the
3
Although his response to Smith is not entirely clear, Rae (1834, 381–82) appears to imply
that even if income were reduced slightly, the intensity of accumulation would increase and
thereby bring about more capital. “It is said capital can only augment by accumulation, and,
as the interference of the legislator takes something from individual revenue, it must also take
from the power to accumulate, and, consequently, instead of augmenting, must tend to diminish
the sum of the capitals of all the individuals in the society, that is the national capital or
stock. . . . The answer to this objection is, that the proceedings of the legislator may increase
the absolute capital and stock of the society, the provision, that is, for future wants, embodied
in the stock of instruments possessed by it, though they may not increase, and may even a little
diminish its relative capital, or the sum which would be brought out by measuring those
instruments with one another. That is the amount of the absolute capital of the society, which
is the proper measure of the wealth of the whole, and of each individual, and that whatever
augments it not only directly, and of itself, advances national wealth, but ultimately, also, does
so indirectly, through the stimulus given to the accumulation principle, and the addition
thence arising to relative capital.” For a more detailed discussion of Rae’s critique of Smith,
see Brewer (1991).
MILL AND THE INFANT INDUSTRY ARGUMENT 123
tracing out, from the principles of his science, rules determining when
the passage of any art is practicable, and when the benefits derived from it
will exceed, or fall short of the necessary expense in effecting the passage.”
Rae suggested that technology transfer policies should be employed if
domestic manufactures could be expected to produce the goods at the same
or a lower price than foreign manufactures, but without explaining when
such an expectation was reasonable. Three distinct advantages would result.
First, the infant industry would save the costs of transporting the imported
goods and thereby increase internal trade, generate additional technological
improvements at home, and “so increase the absolute capital of
the society.” Second, the dislocation of domestic production caused by import
supply disruptions, which causes a “great waste of resources,” would
be avoided. Finally, and most important, greater domestic production of
the previously imported good would “stimulate invention and diminish the
propensity to servile imitation.” As he put it: “Every useful art is so connected
with many, or with all others, that whatever renders its products
more easily attainable, facilitates the operations of a whole circle of arts,
and introduces change—the great agent in producing improvements—
under the most favorable form” (365). Quoting Hamilton approvingly, Rae
suggested that new arts, by “their very existence in any society, gives a
powerful stimulus to the ingenuity of its members.”
Therefore, Rae was broadly supportive of infant industry policies:
The legislator effects his purpose by premiums for successful individual imitations
of the foreign article; by general bounties on the home manufacture; or
by duties on that imported from abroad. . . . it having been made sufficiently
apparent that nothing prevents the branch of industry in question being established,
but the difficulties attending new undertakings, the want of skilled
labor, and a sufficiently accurate knowledge of the properties of the materials
to be employed in the formation of the new instruments, it is then proper to
proceed to direct and general encouragements by bounties or duties. In this
way real capital, and healthy enterprise are directed to the art, the difficulties
attending its introduction overcome in the shortest possible space, and the
commodities yielded by it are produced at less outlay, and afforded at a less
price than that, at which they were before imported. (368)
Rae sounded a note of caution in that the legislator “is never justifiable
in attempt to transfer arts yielding utilities from foreign countries to his
own, unless he has sufficient reason to conclude that they will ultimately
lessen the cost of the commodities they produce. . . . When there are circumstances
particularly unfavorable to the practice of the art, and no countervailing
circumstances particularly favorable to it, the first introduction
of it must always cost the society high, and the subsequent maintaining of
it will in all probability be a burden on the common industry and stock.”
CHAPTER EIGHT124
Unfortunately, he added, “examples of injudicious conduct of the legislator
from inattention to this particular have been not unfrequent” (367–68).
Although Rae is perhaps the most careful early analyst of infant industry
protection, Friedrich List was by far the most popular proponent of protection
in newly industrializing countries. A German political activist, writer,
and sometime academic, List’s book The National System of Political
Economy, first published in German in 1841, attained the status within
protectionist circles that the Wealth of Nations had achieved among free
traders. List based his study largely on historical judgments rather than on
economic analysis because he rejected classical theory, which he thought
suggested that free trade was always beneficial. Instead, List argued that
the appropriate commercial policy of a country depended on its particular
stage of economic development.
List and the classical school agreed on many issues, such as, for example,
the importance of freedom and stability in promoting investment and
other forms of economic activity. But, in List’s mind, two basic points
separated his doctrines from those of the classicals. First, he attacked the
“cosmopolitical economy” of Adam Smith and his followers which, in his
view, wholly ignored the separate and distinct economic interests of a particular
country in a world rife with conflict, fraught with insecurity, and
seething with national identity. List accused Smith and his free-trade followers
of examining only what is best for the world overall under conditions
that he believed presumed an as yet unattained degree of international
cooperation. List’s harsh attacks on the “cosmopolitan school” of Smith
frequently distorted the position of classical writers, who were not romantic
cosmopolitans neglectful of the national interest, and even List admitted
in his preface that his attacks were exaggerated for effect.
Second, List (1885, 133) stated that “the power of producing wealth is
. . . infinitely more important than wealth itself,” and deemed this contrary
to the approach of the classical school. The power of production, by which
he apparently meant the ability to reproduce and augment certain factors of
production such as capital and skilled labor, ensured not only “the possession
and the increase of what has been gained, but also the replacement of
what has been lost.” He accused the classical school of taking a static view
that valued only current wealth (exchangeable value) to the exclusion of
factors that could be used to produce wealth. His ideas about productive
powers were not obviously at variance with the views of the classical economists,
however, because they also emphasized the importance of allowing
capital and skills to accumulate. List believed that more attention should be
devoted to production, however, because “production renders consumption
possible” (233).
When it came to commercial policy, List endorsed many aspects of mercantilist
doctrine. List (1885, 144) believed that the interests of merchants
MILL AND THE INFANT INDUSTRY ARGUMENT 125
did not necessarily reflect the national interest in the development of a
country’s powers of production: “The foreign trade of a nation must not be
estimated in the way in which individual merchants judge it, solely and
only according to the theory of values (i.e., by regarding merely the gain at
any particular moment of some material advantage); the nation is bound to
keep steadily in view all these conditions on which its present and future
existence, prosperity, and power depend.” List repeatedly stressed the fundamental
importance of manufacturing, the benefits of which were economic
and noneconomic and included greater security and independence,
greater division of labor with its impetus to developing skills and accumulating
capital, and the like. Thus, the commodity composition of trade deserved
watchful attention. “It may be stated as a principle,” List (1854, 77)
wrote, “that a nation is richer and more powerful, in proportion as it exports
more manufactured products, imports more raw materials, and consumes
more tropical commodities.”
For these reasons, government support for infant industries was essential.
“The fact that manufacturing industry transforms into productive capital,
wealth, and national powers, explains mainly why protection exerts so
powerful an influence upon the increase of national wealth.” List (1885,
144–45) argued that future benefits from establishing domestic manufactures
would more than compensate for what he fully acknowledged would
be the short-run economic costs of protection:
The nation must sacrifice and give up a measure of material property in order
to gain culture, skill, and powers of united production; it must sacrifice some
present advantages in order to insure to itself future ones. It is true that protective
duties at first increase the price of manufactured goods; but it is just as true
. . . that in the course of time, by the nation being enabled to build up a completely
developed manufacturing power of its own, those goods are produced
more cheaply at home than the price at which they can be imported from
foreign parts. If, therefore, a sacrifice of value is caused by protective duties,
it is made good by the gain of a power of production, which not only secures
to the nation an infinitely greater amount of material goods, but also industrial
independence in case of war. . . . A nation capable of developing a manufacturing
power, if it makes use of the system of protection, thus acts quite in the
same spirit as that landed proprietor did who by the sacrifice of some material
wealth allowed some of his children to learn a productive trade.
List (1885, 226–27) strenuously disputed Smith’s negative remarks
about infant industries:
He wrongly maintains that the revenues of the nation are dependent only on
the sum of its material capital. His own work, on the contrary, contains a
thousand proofs that these revenues are chiefly conditional on the sum of its
CHAPTER EIGHT126
mental and bodily powers, and on the degree to which they are perfected, in
social and political respects (especially by means of more perfect division of
labour and confederation of the national productive powers), and that although
measures of protection require sacrifices of material goods for a time, these
sacrifices are made good a hundred-fold in powers, in the ability to acquire
values of exchange, and are consequently merely reproductive outlay by the
nation. . . . He has not considered the influence of manufactures on the internal
and external commerce, on the civilisation and power of the nation, and on the
maintenance of its independence, as well as on the capability arising from
these of gaining material wealth.
However, not all countries were well suited for such policies. Indeed,
List’s case for protection was carefully circumscribed. Because manufactures
only flourish in temperate climates, tropical countries must never attempt
to acquire manufactures through artificial means.4
And regardless of
the stage of economic development, all countries should have free trade in
agricultural goods and raw materials.5
“The system of protection,” List
(1885, 188, 309) wrote, “can be justified solely and only for the purpose of
the industrial development of the nation. . . . Measures of protection are
justifiable only for the purpose of furthering and protecting the internal
manufacturing power, and only in the case of nations which through an
extensive and compact territory, large population, possession of natural
resources, far advanced agriculture, a high degree of civilization and political
development, are qualified to maintain an equal rank with the principal
agricultural manufacturing commercial nations.”
List drew upon his reading of history in proposing the best commercial
policy for countries at different stages of economic development: “History
teaches us how nations which have been endowed by Nature with all resources
which are requisite for the attainment of the highest grade of wealth
and power, may and must . . . modify their [commercial] systems according
to the measure of their own progress: in the first stage, adopting free trade
4
“A country of the torrid zone would make a very fatal mistake, should it try to become a
manufacturing country. Having received no invitation to that vocation from nature, it will
progress more rapidly in riches and civilization if it continues to exchange its agricultural
productions for the manufactured products of the temperate zone. It is true that tropical countries
sink thus into dependence upon those of the temperate zone, but that dependence will not
be without compensation, if competition arises among the nations of temperate climates in
their manufacturing industry in their trade with the former. . . . This competition will not only
ensure a full supply of manufactures at low prices, but will prevent any one nation from taking
advantage by its superiority over the weaker nations of the torrid zone” [List (1854, 75–76)].
5
List (1885, 324, 187) wrote: “Free trade in agricultural products and raw materials is
useful to all nations at all stages of their industrial development.” He believed that production
of “provisions and raw materials . . . needs no protection, and in which the restriction of
commercial intercourse must be disadvantageous under all circumstances to both nations—to
that which imposes, as well as to that which suffers from such restrictions.”
MILL AND THE INFANT INDUSTRY ARGUMENT 127
with more advanced nations as a means of raising themselves from a state
of barbarism, and of making advances in agriculture; in the second stage,
promoting the growth of manufactures, fisheries, navigation, and foreign
trade by means of commercial restrictions; and in the last stage, after reaching
the highest degree of wealth and power, by gradually reverting to the
principle of free trade and of unrestricted competition in the home as well
as in foreign markets” (115).
Unlike Rae or Hamilton, List did not mention any preference for subsidies
over tariffs as the way to promote industry. As for the height of protective
tariffs, List observed that “it may in general be assumed that where any
technical industry cannot be established by means of an original protection
of forty to sixty per cent and cannot continue to maintain itself under a
continued protection of twenty to thirty per cent the fundamental conditions
of manufacturing power are lacking” (313). List was prepared to wait
decades before allowing protection to expire, calling it “ridiculous to allow
a nation merely a few years for the task of bringing to perfection one great
branch of national industry” (319).
List never disparaged the ultimate goal of worldwide free trade; indeed,
he embraced it.6
He simply advocated temporary protective measures in
countries passing through a certain stage of development to ensure that
they could trade on an equal footing with more advanced countries in producing
manufactured goods. As he (1885, 129, 131) put it, “The system of
protection, inasmuch as it forms the only means of placing those nations
which are far behind in civilisation on equal terms with the one predominating
nation [England] (which, however, never received at the hands of
Nature a perpetual right to a monopoly of manufacture, but which merely
gained an advance over others in point of time), the system of protection
regarded from this point of view appears to be the most efficient means
of furthering the final union of nations, and hence also of promoting true
freedom of trade. . . . In order to allow freedom of trade to operate naturally,
the less advanced nations must first be raised by artificial means to
that stage of cultivation to which the English nation has been artificially
elevated.”
Over the course of the nineteenth century, List came to have an immense
popular impact. By the end of the century such eminent British economists
as Alfred Marshall acknowledged and accepted many of List’s basic ideas
about infant industries in developing countries. But most economists did
not accept the infant industry argument on List’s terms and with reference
to List’s works. They were suspicious of his historical analysis, skeptical
that it could provide a careful analysis of the problems faced by infant
6
List (1885, 122) simply believed that there were important political prerequisites: “If . . .
we assume a universal union or confederation of all nations as the guarantee for an everlasting
peace, the principle of international free trade seems to be perfectly justified.”
CHAPTER EIGHT128
industries or useful guidance about the conditions under which protection
was or was not advisable. Under ideal circumstances, the implications of
economic theory did not depend upon historical circumstances, as was the
case with comparative advantage. And List did nothing to advance the theory
underlying the infant industry case because this was not his purpose.
Thus, the infant industry doctrine did not gain formal acceptance into
classical trade theory until 1848, when John Stuart Mill published the first
edition of his Principles of Political Economy. The endorsement by an
economic theorist of first rank was not so easily dismissed as similar statements
coming from a Hamilton or a List. Mill’s ([1848] 1909, 922) original
statement was as follows:
The only case in which, on mere principles of political economy, protecting
duties can be defensible, is when they are imposed temporarily (especially in
a young and rising nation) in hopes of naturalizing a foreign industry, in itself
perfectly suitable to the circumstances of the country. The superiority of one
country over another in a branch of production often arises only from having
begun it sooner. There may be no inherent advantage on one part, or disadvantage
on the other, but only a present superiority of acquired skill and experience.
Acountry which has this skill and experience yet to acquire, may in other
respects be better adapted to the production than those which were earlier in
the field: and besides, it is a just remark of Mr. Rae, that nothing has a greater
tendency to promote improvements in any branch of production than its trial
under a new set of conditions. But it cannot be expected that individuals
should, at their own risk, or rather to their certain loss, introduce a new manufacture,
and bear the burthen of carrying it on until the producers have been
educated up to the level of those with whom the processes are traditional. A
protecting duty, continued for a reasonable time, will sometimes be the least
inconvenient mode in which the nation can tax itself for the support of such an
experiment. But the protection should be confined to cases in which there is
good ground of assurance that the industry which it fosters will after a time be
able to dispense with it; nor should the domestic producers ever be allowed to
expect that it will be continued to them beyond the time necessary for a fair
trial of what they are capable of accomplishing.
Mill’s standing and reputation among economists gave intellectual credibility
to the infant industry argument for the first time. Economists and
others who viewed free trade as the best policy for all countries regardless
of the circumstances were dismayed by the respectability Mill lent to protection.
Richard Cobden, the great free-trade activist in mid-nineteenthcentury
Britain, reportedly lamented on his deathbed that “I believe that the
harm which Mill has done to the world by the passage in his book on
Political Economy in which he favors the principle of protection in young
communities has outweighed all the good which may have been caused by
MILL AND THE INFANT INDUSTRY ARGUMENT 129
his other writings.”7
And Alfred Marshall ([1890] 1925, 259) later remarked
that “when John Stuart Mill ventured to tell the English people that
some arguments for protection in new countries were scientifically valid,
his friends spoke of it in anger—but more in sorrow than in anger—as his
one sad departure from the sound principles of economic rectitude.”
Indeed, complaints soon reached Mill on how his statement was being
distorted by protectionists to justify high tariffs in the United States, Canada,
and Australia in the 1860s. In his correspondence, Mill condemned
any general policy of protection—“an organized system of pillage of the
many by the few,” he called it—but reiterated that, in principle, the infant
industry claim to protection was valid.8
“It may sometimes be a good calculation
for the future interests of the country to make a temporary sacrifice
by granting a moderate protecting duty for a certain limited number of
years, say ten, or at the very most twenty, during the latter part of which the
duty should be on a gradually diminishing scale, and at the end of which it
should expire.”9
But the complaints persisted and by the late 1860s Mill
grew to question his own approval of the doctrine. To one correspondent
Mill sighed, “But I confess that I almost despair of this general understanding
[of the limits of the infant industry case] being ever practically established.
I find that in Australia, protection is not advocated in this form or for
this purpose, but that the vulgarest and most exploded fallacies are revived
in its support.”10
Eventually, Mill recanted his view that import protection was an appropriate
means of promoting infant industries, although he never abandoned
his belief that such industries could exist and that this in principle constituted
a genuine exception to free trade. “Though I still think that the introduction
of a foreign industry is often worth a sacrifice, and that a temporary
protecting duty, if it were sure to remain temporary, would probably be the
best shape in which that sacrifice can be made, I am inclined to believe that
it is safer to make it by an annual grant from the public treasury, which is
not nearly so likely to be continued indefinitely, to prop up an industry
which has not so thriven as to be able to dispense with it.”11
Curiously, Mill never incorporated these views into later editions of the
7
Quoted in George Armitage-Smith (1898, 53).
8
JSM, XVII, 1798. References to Mill’s work are from The Collected Works of John Stuart
Mill (Toronto: University of Toronto Press, 1965–91), hereafter referred to as JSM followed
by volume and page number.
9
JSM, XVI, 1044.
10
JSM, XVI, 1420.
11
JSM, XVI, 1516. “I am now much shaken in the opinion, which has so often been quoted
for purposes which it did not warrant; and I am disposed to think that when it is advisable, as
it may sometimes be, to subsidise a new industry in its commencement, this had better be done
by a direct annual grant, which is far less likely to be continued after the conditions which
alone justified it have ceased to exist” (JSM, XVI, 1520).
CHAPTER EIGHT130
Principles. In the sixth edition of 1865, Mill (1909, 923) added the following
passage to his infamous paragraph:
The expenses of production being always greatest at first, it may happen that
the home production, though really the most advantageous, may not become
so until after a certain duration of pecuniary loss, which it is not to be expected
that private speculators should incur in order that their successors may be
benefited by their ruin. I have therefore conceded that in a new country a
temporary protecting duty may sometimes be economically defensible; on
condition, however, that it be strictly limited in point of time, and provision be
made that during the latter part of its existence it be on a gradually decreasing
scale. Such temporary protection is of the same nature as a patent, and should
be governed by similar conditions.
Then, in the seventh and final edition of 1871, Mill added the further qualification
that replaced “a protecting duty . . . will sometimes be” with
“might sometimes be,” and to add “it is essential that the protection should
be confined. . . .”
In the decades after 1848, Mill’s qualified endorsement of infant industry
protection failed to attract much support among economists. Mill’s paragraph
succeeded in putting them on the defensive, but economists remained
skeptical. Even Mill’s foremost disciple, John E. Cairnes (1874,
403), dismissed infant industry protection because “the inevitable result
is that industry becomes unprogressive wherever it is highly protected.”
Cairnes characterized Mill’s statement as the “obiter dictum of a great
writer” and called attention to the “strict limitations” Mill had set down
with his case. But he added that “with or without such limitations, however,
I cannot but think that the position is untenable.” Henry Fawcett
(1878, 111) agreed that Mill’s argument would be conclusive “if there were
a reasonable probability that the conditions under which he supposes that
such a protective duty could be imposed would ever be realized.” But it has
been “incontestably shown” that “it is absolutely impossible to impose a
protective duty under the stipulations on which Mr. Mill so emphatically
insists.”
William Graham Sumner (1885, 117) believed that Mill’s case was
“conceivable” and therefore not “absurd,” but maintained that “I strenuously
dissent from Mill’s doctrine even as he limits it.” “Manufactures
grow up as population increases and capital accumulates, and, in the natural
order of industry, are best developed in countries of dense population
and accumulated wealth,” observed Henry George (1886, 165) in rejecting
the infant industry argument. “Seeing this connection, it is easy to mistake
for cause what is really effect, and to imagine that manufacturing brings
population and wealth.” Finally, J. S. Nicholson (1901, 364–65) commented
that “temporary protection is impossible owing to the creation of
MILL AND THE INFANT INDUSTRY ARGUMENT 131
vested interests, that new countries especially require capital, which is repelled
and diminished by protection, and that the artificial forcing of new
industries is not advantageous in the long run.” Echoing George, Nicholson
argued that “the best way to promote the higher forms of industry is not
by the simple process of exclusion, but rather by improvements in the education
of the people.”
Despite such skepticism, key questions about the infant industry case for
protection remained unasked and unanswered. The first question related to
identifying the specific market failures that give rise to the necessity for
government intervention. The second question related to whether, given
the existence of some market failure, the expected value of government
action was positive. Yet these fundamental issues were virtually swept
aside toward the end of the nineteenth century when economists were reacting
against what they viewed as dogmatic laissez-faire arguments
against government intervention that had become associated with political
economy. A greater willingness to accept market failures and concede a
greater economic role to the government served to insulate the infant industry
argument from greater scrutiny, giving the infant industry doctrine
the appearance of greater strength in economic analysis than it actually
had.
In his widely read textbook, for example, Henry Sidgwick (1887, 489ff)
of Cambridge University strongly endorsed Mill’s passage and even made
the incredibly bold claim that “the argument for temporary protection . . .
is theoretically valid from what I have called a ‘cosmopolitan’ point of
view,” that is, from the standpoint of the world’s overall economic welfare.
In Sidgwick’s words, “It is quite possible that the cost incurred may be
compensated to the community by the ultimate economic gain accruing
from the domestic production of the commodity previously imported;
while yet the initial outlay, that would be required to establish the industry
without protection, could not be expected to be ultimately remunerative to
any private capitalists who undertook it.” Here Sidgwick raised the first
key issue: if the government recognizes that a currently unprofitable industry
is potentially successful after a period of protection, what prevents private
firms and entrepreneurs from borrowing in capital markets to cover
their initial losses? Private action would fail, he argued, “if the difficulties
of introducing the industry were of such a kind that, when once overcome
by the original introducers, they would no longer exist for others or would
exist in a much smaller degree.” This implied some externality, but regrettably
he did not elaborate.
Sidgwick instead offered the example of two regions equally suited for
producing manufactures, one of which exported manufactures and the
other agricultural goods. The region exporting agricultural products could
then save on the transportation costs of imported manufactures by estab-
CHAPTER EIGHT132
lishing domestic production itself; in other words, temporary protective
duties would bring about a gain that would “consist chiefly” in saving the
cost of transport.12
Sidgwick did not explain why comparative advantage
failed in this particular instance or how world welfare would increase as a
result. This savings-of-transportation-costs argument for infant industry
protection was not new (having been discussed by Rae and dating back to
the mercantilists), and Sidgwick was essentially resurrecting the same case
made by the well-known American protectionist, Henry Carey (1858).
Yet this savings-of-transportation-costs argument completely fails as a
case for protection. From the 6th edition of his Principles in 1865, Mill
(1909, 925ff) scornfully called Carey’s widely read argument for protection
“totally invalid.”13
Mill strenuously rejected it and had, in fact, totally
demolished it in the Principles. The Carey-Sidgwick doctrine completely
ignored the insights of comparative advantage and failed to recognize that,
in spite of the transportation costs, there is a savings to the country from
procuring the good from abroad. As Mill (1909, 923) put it, “The burthen
[of transportation costs] is borne for a more than equivalence advantage. If
the commodity is bought in a foreign country with domestic produce in
spite of the double cost of carriage, the fact proves that, heavy as that cost
may be, the saving in cost of production outweighs it, and the collective
labour of the country is on the whole better remunerated than if the article
were produced at home.”
There had also been skirting around the issue of whether infant industry
protection was justifiable on the basis of cost-benefit analysis. Charles F.
Bastable (1887, 136–37), a professor at Trinity College (Dublin), conceded
that the infant industry argument is “the most plausible case which can be
made for protection.” But Bastable pointed out that government intervention
could not be called a success simply because it enabled an industry to
overcome a historical handicap and survive. Rather, a more decisive question
was posed: “Will the certain and immediate loss, resulting from protection,
be outweighed by the future gains from the new industry?” This
question not only applied a basic cost-benefit test to infant industry policies,
but, in Bastable’s opinion, the practical problems associated with such
policies “strongly impress us with the belief that this special case is in
reality no exception to the rule of freedom in international trade.” Bastable
agreed that arguments for protection of manufactures on noneconomic
grounds were prevalent, but on the demonstrable criteria of economic gain,
something even Mill himself had been vague about, was more stringent.
Until Bastable’s statement, economists had noted the costs associated
with infant industry protection, but failed to identify clearly the gains from
12
As Jacques Melitz (1963) points out, transportation costs were an integral part of
Sidgwick’s trade theory.
13
To one correspondent, Mill even wrote about Carey that his was “about the worst book
on political economy I ever read” (JSM, XVII, 1589).
MILL AND THE INFANT INDUSTRY ARGUMENT 133
having an industry naturalized. If the rate of payments to factors of production
was determined in other sectors of the economy and the infant industry
merely drew these factors away from other activities, factors would earn no
more than their opportunity cost and there would be no gain from having
created a new industry. Rather, the industry that developed due to protection
must create some quasi-rents (or producer surplus) for it to prove
beneficial to the economy.
Once the costs and the benefits had been identified, then they could be
compared. Paul-Gustave Fauveau (1873), a French mathematician and
contributor to French economic journals, calculated the precise conditions
under which infant industry protection would bring a net gain. Suppose a
were the mean annual cost required to establish an infant industry and b
were the mean annual benefits generated by the industry after infant industry
protection was removed. If x were the number of years of infant industry
protection, the present discounted value of the costs of the policy (assuming
interest rate r):
a a a
a + ______ + ______ + … + ________ ,
(1 + r) (1 + r)2
(1 + r)x−1
which would sum to:
a 1⎡ ⎤
⎢ ⎥
⎣ ⎦
__ ⋅ (1 + r) ⋅ 1 − ______ .
r (1 + r)x
The gains from the infant industry after year x would be an infinite sum of
b that would amount in present value terms to:
b 1__ ⋅ (1 + r) ⋅ ______ .
r (1 + r)x
Equating the discounted stream of future benefits from the infant industry
to the discounted sum of initial costs, such that there would be no net gain
from the infant industry policy, yields the following relationship:
a⎛ ⎞
⎜ ⎟
⎝ ⎠
x ⋅ log (1 + r) = log 1 + __ .
b
Assuming an interest rate of 5 percent, Fauveau calculated the mean annual
“break-even” gain that would be necessary to compensate exactly for the
loss from import duties. If protection lasts 5 years (x = 5), then the mean
annual gains (in perpetuity) from the infant industry must be 28 percent of
the mean annual loss to ensure no net gain or loss from the policy. If protection
continues for 10 years, the mean annual gain must be 63 percent of the
CHAPTER EIGHT134
mean annual loss; for 15 years, 108 percent of annual loss; for 20 years, 165
percent; for 30 years, 332 percent; for 50 years, 1,047 percent. This calculation
demonstrates the cost-benefit hurdle that any infant industry policy has
to surmount for the expected value of intervention to be positive. What
economists including Mill had failed to do was to address the underlying
economic structure of the infant industry argument in terms of specific
market failures, specify the gains that accrue to a nation from naturalizing
a certain industry, and then describe how these gains could compensate for
the loss incurred while protecting the industry.
The infant industry argument received yet another lease on life, and
again escaped careful scrutiny, when two leading economists of the next
generation merely accepted the case in principle without dissecting it. Alfred
Marshall (of Cambridge University) and Frank Taussig (of Harvard
University) were both agnostic as to the underlying theory behind infant
industries and pursued a case-study approach to assess such policies. In
various writings, Marshall expressed his belief that the classical economists
had been too dogmatically opposed to the infant industry argument
and that protection in the newly industrializing countries of the United
States and Australia was not an unmitigated evil.14
Marshall ([1903] 1926,
392) went so far as to say that “protection to immature industries is a very
great national good” and that, while costly in some instances, “it would
have been foolish for nations with immature industries to adopt” free trade.
Marshall would often describe his visit to America in 1875 during which he
concluded that the overall costs and benefits of protection were roughly
balanced.
Taussig also fully accepted the infant industry argument when the impediments
to establishing an industry were artificial, not natural or permanent.
In studying the cotton textile and iron industries in the early nineteenth-century
United States, Taussig (1883, 66–68) found that although
“the conditions existed under which it is most likely that protection to a
young industry may be advantageously applied . . . little, if anything, was
gained by the costly protection which the United States maintained in the
first part of this century.” As this constituted just one experiment, Taussig
insisted that “the intrinsic soundness of the argument for protection to
young industries is therefore not touched by the conclusions drawn from
the history of its trial in the United States.” Indeed, he maintained that
whether protection is beneficial or not is “simply a question of probability
for the given case.”15
14
Phyllis Deane (1990) provides an overview of Marshall’s views on free trade.
15
Certainly there was the danger that, as Taussig (1905, 47) put it, protection, “so far from
leading to improvements and eventual cheapening, leads to the retention of antiquated and
inefficient methods of production.” But he also argued that ten years might be too brief a trial
period for infant industry protection, with thirty years not necessarily being unreasonable.
MILL AND THE INFANT INDUSTRY ARGUMENT 135
Marshall and Taussig did nothing to advance or qualify the conceptual
basis for the infant industry argument. While their own studies provided
little support for infant industry policies in practice, their uncritical acceptance
of the economic argument perpetuated the impression that the infant
industry case constituted a valid and important exception to free trade. As
A. C. Pigou (1906, 13), one of Marshall’s prize students, declared, “Of the
formal validity of List’s [infant industry] argument there is no longer any
dispute among economists,” despite the fact that since Mill’s statement
there had really been no deeper examination of the precise theoretical issues
involved.
Over the first half of the twentieth century, the infant industry argument
remained a universally acknowledged theoretical exception to free trade,
despite the continued skepticism among economists about such protection
in practice. Over these fifty years, however, the theory behind the argument
remained vaguely formulated. Not only was it difficult to lay down general
rules for ascertaining the likelihood of infant industry protection being successful,
it was not even clear what specific market failures and other underlying
conditions gave rise to the infant industries in the first place. What
was the specific barrier that necessitated government intervention: the lack
of a domestic supply of skilled labor? insufficient accumulated production
experience? failures in the capital market? Depending upon the particular
factors that prevented infant industries from arising and maturing on their
own, the implications for trade policy could be quite different.
When economists finally began to put more economic structure on the
argument, the case for protection appeared more limited than previously
thought. Because the argument was for temporary (rather than permanent)
protection, the infant industry case was inherently dynamic and involved
some irreversibilities, such as accumulated dynamic scale economies resulting
from learning by doing. In this context, the focus turned to identifying
the precise point of market failure because that determined which
method of government intervention was best suited to improving upon a
laissez-faire outcome. James Meade (1955, 255–57) described the infant
industry argument as follows: if a firm tries to enter a market it will initially
incur a loss, but “after a time experience would bring with it the necessary
skills and know-how and the industry would turn out to be an economic
one for the country to undertake.” However, Meade pointed out, “infancy
as such provides no argument even for temporary State support.” If the firm
can eventually earn a suitable rate of return, then private enterprise in the
capital markets will have an incentive to provide these funds and “there
will be no case for a State subsidy.” Thus, if capital markets were efficient
there would be no need for government action. And even if capital markets
were not efficient, one would be hard pressed to explain why the government
should not attempt to remedy the particular deficiency in the capital
CHAPTER EIGHT136
market rather than impose trade restrictions (which would fail to solve the
underlying problem).
An alternative market failure could lie in the acquisition of technical
knowledge by the firm. Meade pointed out that “it may be difficult for one
infant to learn without thereby affecting the knowledge of other infants.” In
other words, an initial investment by one firm could affect the production
conditions for all subsequent firms if that knowledge is easily transferable.
If the knowledge generated by learning by doing or research and development
expenditures spill over costlessly to other firms, then it is conceivable
that no firm will undertake the initial investment. “In such a case the temporary
subsidization of the first firm may be socially desirable; but this
would be so not because infants have to learn but because infants teach
each other.” The further qualification here is that spillovers must be geographically
local or national in scope; if such knowledge spillovers were
worldwide in nature, there would be no special barrier to domestic firms in
acquiring that knowledge from firms in exporting countries.
The principle of policy targeting implicit in Meade’s analysis suggests
that the most efficient government intervention addresses the failure of
marginal conditions between price and cost to hold at the precise source of
their divergence.16
In this vein, Robert Baldwin’s (1969) classic critique
of the infant industry argument for protection stresses that, even if the precise
market failure associated with infant industries has been specified, a
trade policy intervention does not necessarily provide a remedy that will
ensure the maturation of the infant. Baldwin noted that import protection
alone fails to provide the right incentives for an infant firm to make additional
investments in acquiring technological knowledge. Nor does it necessarily
improve the firm’s ability to retain the benefits of its investments
in knowledge, but does serve to make old production techniques profitable.
The appropriate policy actions should focus on correcting the specific,
underlying problems thought to be associated with acquiring new technologies
and investments in new techniques.17
As Baldwin (1969, 303) justly
concluded, “If the infant industry argument for tariff protection is worthy
of its reputation as the major exception to the free trade case, it should be
16
This is the underlying logic of the theory of domestic divergences, discussed in chapter
10.
17
As Harry Johnson (1965, 28) explained, “Once knowledge of production technique is
acquired, it can be applied by others than those who have assumed the cost of acquiring it; the
social benefit at least potentially exceeds the private benefit of investment in learning industrial
production techniques, and the social use of the results of such learning may even reduce
the private reward for undertaking the investment. Where the social benefits of the learning
process exceed the private benefits, the most appropriate governmental policy would be to
subsidize the learning process itself, through such techniques as financing or sponsoring pilot
enterprises on condition that the experience acquired and techniques developed be made available
to all would-be producers.”
MILL AND THE INFANT INDUSTRY ARGUMENT 137
possible to present a clear analytical case, based upon well-known and generally
accepted empirical relationships unique to infant industries, for the
general desirability and effectiveness of protective duties in these industries.”
Nearly a century and a half since Mill lent his support to the infant
industry argument for protection, the case has still not achieved this level
of intellectual coherence.
⅐ ⅐ ⅐
Despite the intuitively appealing metaphor of “infant” industries, analytical
progress in assessing this argument for protection has come extremely
slowly since Mill’s qualified endorsement. Although hampered by a lingering
sense of vagueness, the infant industry argument in modern treatments
now relates to hurdles faced by new firms in acquiring knowledge or capital.
To the extent that government intervention is called for it is to improve
upon the existing conditions of appropriability of knowledge investments
or improving the functioning of capital markets. Trade interventions are
not directly appropriate because those improvements may be desirable regardless
of whether the industry in question is involved in international
trade. As a result, this particular argument for protection is not nearly as
prevalent or supportable today as it was several decades ago. Still, the infant
industry argument has been difficult to dismiss altogether and it continues
to occupy an uneasy place in the theory of commercial policy.
Chapter Nine
GRAHAM AND THE
INCREASING RETURNS ARGUMENT
THE INFANT INDUSTRY argument for protection held that temporary protection
might enable a domestic industry to reach a degree of efficiency such
that it could, at some point, export without assistance at world prices. In the
1920s, Frank Graham, an economics professor at Princeton University,
sought to describe conditions under which permanent protection could
benefit a country. If manufacturing was subject to increasing returns to
scale and agriculture was subject to decreasing returns to scale, then a
country specializing in agriculture and importing manufactured goods
could be depriving itself of production in a high productivity sector.
Graham described the disadvantages of this situation and argued that a
permanent tariff on manufactures could prove superior to free trade. As
with previous arguments for protection, his case provoked sharp debate,
but it foundered on the following criticism: increasing returns that are internal
to the firm are incompatible with market competition. Still, Graham
succeeded in bringing attention to the potential effects of external economies
in generating arbitrary patterns of specialization and trade.
⅐ ⅐ ⅐
The classical theory of comparative advantage, which achieved prominence
in chapter 7 of Ricardo’s Principles, assumed one factor of production
(labor) and constant costs of production: if the quantity of labor
employed in the production of a good doubled, output would also double.
Yet trade was often described in the context of several factors and different
cost relationships. In 1815, Thomas Malthus, David Ricardo, and Edward
West all independently applied the notion of diminishing returns to scale in
the context of agricultural production: as more labor was applied to a fixed
amount of land, the less each additional laborer was able to produce. Ricardo’s
famous critique of the Corn Laws skillfully used diminishing returns
(or, alternatively, increasing costs of production) in agriculture to
describe how rents, profits, and wages were determined and to assess the
impact of trade policy on income distribution. Unlike Ricardo and Malthus,
West also called attention to the possibility of increasing returns in
manufacturing, in which the costs of production might decline as the scale
of production increased. West (1815, 25) suggested that “the division of
labor and application of machinery renders labor more and more produc-
GRAHAM AND THE INCREASING RETURNS ARGUMENT 139
tive in manufactures, in the progress of improvement.” This effect was also
present in agriculture, but was more than counterbalanced by recourse to
inferior land, a nonaugmentable factor of production, which gave rise to
diminishing returns. West’s distinction between diminishing returns in agriculture
and increasing returns in manufacturing was adopted by other
classical economists and became established as a theme in economics that
continues to the present day.1
However, the implications of increasing returns
for trade and commercial policy were not, at this point, drawn out.
Unlike the terms of trade and the infant industry arguments, the debate
about increasing returns was the first in which the main participants were
American economists rather than their British counterparts. Economists in
the United States had long contended with or even advanced the casual
argument made by protectionists there that import tariffs on manufactures
were desirable to promote greater output in increasing returns industries.
American economists also confronted the related belief that, when a domestic
industry is characterized by increasing returns, an import tariff
might not result in higher domestic prices. Rather, the popular argument
reasoned, a tariff might actually reduce prices because domestic output
could expand and serve the market at a lower cost. Francis Walker (1903)
attempted with little success to illustrate that argument more formally. He
used numerical examples loosely based on increasing returns and ostensibly
designed to demonstrate the potential gain from tariffs if prices of
traded commodities fell as a result.2
Thomas Carver (1902) did not reject the possibility of lower prices altogether,
but at least recognized that if increasing returns at the firm level
continued indefinitely the industry would be driven toward a one-firm monopoly.
In this case, a tariff would simply strengthen this monopoly power
and allow a higher price to be exacted from domestic consumers.3
But most
economists were surprisingly lax about recognizing the potential difficulties
that increasing returns might create for the theoretical case in favor of
free trade. Frank Taussig (1927, 83), for example, agreed that increasing
returns “may alter conditions under which international trade is carried
on,” but nonchalantly dismissed them as “not of a novel kind, and therefore
call for no new analysis.”
It took a British economist, J. S. Nicholson (1897, 308–9), a professor of
political economy at the University of Edinburgh, to point out that increasing
returns might create problems for the theory of comparative advantage.
1
Nassau Senior (1826, 86), for example, proposed the following economic law, that “every
increase in the number of manufacturing labourers is accompanied not merely by a corresponding,
but by an increased productive power,” and asserted that if employment in the
textile sector doubled, output would more than double.
2
Jacob Viner’s (1937, 475) harsh but reliable judgment is that “his procedure is defective
in almost every conceivable particular . . . [and] his results are totally devoid of significance.”
3
See also Alfred Marshall’s ([1890] 1925, 261–62) related discussion.
CHAPTER NINE140
Nicholson envisioned the following scenario: suppose wheat production
was subject to diminishing returns to scale (wherein the marginal product
of labor declined as more labor was employed), while cloth production was
subject to increasing returns to scale (wherein the average product of labor
increased with employment). Specialization and trade would imply sharply
different outcomes for two countries. The country having a comparative
advantage in the production of cloth would enjoy both a rise in the average
product of labor in cloth (as output increased) and in the marginal product
of labor in wheat (as output contracted). This would lead to an increase in
the wage rate; Nicholson, as others of his era were prone to do, implied that
anything that increased labor’s share in national income was inherently
desirable.
The opposite occurs in the country having a comparative advantage in
wheat: the marginal product of labor in wheat would fall as output expands,
while the withdrawal of labor from cloth would decrease the average product
of labor in that sector. If cloth sells at the same price per yard as wheat
per bushel, then this process would usually stop when the labor used to
produce 1,000 yards of cloth could be used to produce 1,000 bushels of
wheat. However, with different returns to scale a country might use resources
to produce less than 1,000 bushels of wheat because the standard
analysis “takes no account of the reduction of the average yield to labour in
cloth as the production is diminished.” In this case, the extra labour in
wheat could yield less than 1,000 bushels and the country “will obtain less
cloth than before and the total national income will be less.” For this country,
which would completely specialize in wheat, Nicholson argued that the
“only compensation would be in obtaining more cloth than before for the
wheat exported,” that is, a sufficiently large improvement in the terms of
trade.
Nicholson’s early but insightful analysis came just short of clinching his
case because he neglected to illustrate directly the loss suffered by the
country specializing in the diminishing returns sector; he only indirectly
addressed the gains-from-trade issue and his argument about reduced national
income was incomplete by itself. His awkward use of marginal analysis
in agriculture and average analysis in manufactures signaled a potential
problem in examining the international trade equilibrium with this sort
of increasing returns. Marginal analysis in agriculture was standard: output
would expand until a competitive equilibrium was established at which the
(increasing) marginal cost of producing the good was equal to its price.
This would not suffice in considering manufacturing: if marginal cost was
a decreasing function of output, there would be no profits on the earlier,
higher cost units of output when marginal cost was set equal to price. Thus,
Nicholson was forced to couch his discussion of manufacturing in terms of
average productivity (or costs): as output increased, the average cost of
GRAHAM AND THE INCREASING RETURNS ARGUMENT 141
production over all units of output would fall. This situation was potentially
compatible with competitive equilibrium.
Curiously, Nicholson’s example drew little contemporary comment or
debate.4
In 1923, however, Frank Graham constructed a very similar example
that appeared to demonstrate the loss suffered by the country that did
not specialize in the increasing returns industry. Holding that comparative
advantage is not an “infallible criterion” of the best commercial policy,
Graham (1923, 200) argued that when manufacturing is subject to increasing
returns to scale, “protection to manufactures may advantageously be
continued much longer than would seem adequate to cover the infant stage,
whether or not the industry could maintain itself without such aid.” Proponents
of temporary infant industry protection conceded too much, in
Graham’s view, because “it may be to a country’s economic advantage to
protect an industry which could not grow up or survive without protection
and which never will be able to survive without it, an industry which has
not comparative advantage when the protective duty is first levied nor ever
attains one under it” (202–3).
To illustrate his point, Graham introduced a numerical example of comparative
costs and trade in watches (subject to increasing returns) and
wheat (subject to decreasing returns). Suppose in the absence of trade a
country can use a unit of labor to produce 40 units of wheat or 30 watches.
If the international ratio of exchange is 40 units of wheat for 35 watches,
the country has comparative advantage in wheat: with trade and two units
of labor, it could consume 40 units of wheat and 35 watches, 5 more
watches than it could without trade. But the labor costs of production,
under Graham’s assumptions, are not invariant to the movement of labor
between the two sectors. As labor shifts into wheat production and confronts
diminishing returns, output becomes more costly to obtain and the
marginal product of labor falls to 35 units of wheat; as labor leaves the
increasing returns watch industry, output there also becomes more costly to
obtain and labor can only produce 20 watches. If the international exchange
ratio remains 40 units of wheat for 35 watches, the country at that
particular point still benefits from trade. Without trade at that point the
country could have 35 units of wheat and 20 watches; with trade it could
have 30 units of wheat and 35 watches and, as 5 extra watches are worth
more than 5 units of extra wheat, the country has a higher real income.
But that is an incorrect comparison, Graham noted. The correct comparison,
he pointed out, is no trade (with labor producing 40 units of wheat or
30 watches) versus trade (with labor producing 35 units of wheat or 20
4
L. L. Price’s (1898, 63) review of Nicholson’s book merely noted that the author “shows
the importance of the possible effects of the two laws (of returns) on the terms of exchange . . .
his judgment on the theoretical foundation of protection is expressed with far more caution
and discrimination than older advocates of free trade would have exhibited.”
CHAPTER NINE142
watches). With trade, the country gets 10 fewer units of wheat and 5 more
watches than without trade, but this is a net loss because 10 units of wheat
are worth more than 5 watches. Thus, Graham concluded, “At any given
moment . . . it will pay [for the country] to specialize in wheat, but the final
result of the specialization is to bring about a situation in which the citizens
of [the country] get less reward for their efforts than if they had never
carried on international trade at all” (207).
Graham recognized that if the costs he had assumed were marginal costs,
then the harmful effects of specialization were not inevitable. In this case,
the higher cost of producing wheat applies to the final unit of output, not to
the previous (infra-marginal) units to the same degree.5
(In other words, the
average product of labor is higher than the marginal product of labor, so
simply multiplying the total amount of labor by its marginal product would
understate total output.) But if the costs were average costs, then the probability
of loss would depend upon the extent to which output expands and
the rapidity with which costs rise as a result of trade. In the specific example
considered by Graham, “the conclusion that [the] country under the
conditions assumed must lose by free trade is inevitable.” This result provides
the basis for “advantageous permanent protection”: because the
country is better off in autarky or with less trade, it is “economically benefited
by protection and may do well to keep it indefinitely” (208).
Although the country with comparative advantage in the decreasing returns
sector would suffer losses, Graham also showed that free trade would
increase overall world output. For the other country (or countries) specializing
in the increasing returns industry, the amount of labor needed to produce
both wheat and watches would fall with the opening of trade and they
would reap an unambiguous gain. In producing watches, Graham repeated
Nicholson’s use of average cost analysis. Once again, the cost decline
could not be at the margin because that would imply no profits on the
initial, higher cost units. Instead, the lower unit cost must pertain to the
entire output; as Graham put it, “An extension of output will be reflected
here in a lower unit cost for the whole product and not for the new increment
merely, and all producers must have approximately equal costs or be
put out of business by their competitors” (208–9).
Graham concluded that “it may well be disadvantageous for a nation to
concentrate in production of commodities of increasing cost despite a comparative
advantage in those lines; it will the more probably be disadvantageous
to do so if the world demand for goods produced at decreasing cost
is growing in volume more rapidly than that for goods produced at increasing
cost” (210). He dismissed the idea that the terms of trade would im-
5
Of course, income distribution, in the form of higher rent to owners of land, would change
in this case.
GRAHAM AND THE INCREASING RETURNS ARGUMENT 143
prove for the country specializing in the decreasing returns industry; that is,
the price of wheat would rise relative to the price of watches because of the
scarcity of resources used in the production of wheat and increasing returns
in the watch industry. “There is no reason for supposing that this would
happen,” he maintained without explanation.
Implicit in these early analyses by Nicholson and Graham were two distinct
problems with free trade under increasing returns. First, increasing
returns implied multiple equilibria. Because the marginal product of labor
was increasing with the amount of labor in the manufacturing sector, one
could imagine one equilibrium in which no labor was devoted to manufacturing
(and output in that sector would be zero) and another equilibrium in
which all labor was devoted to manufacturing. Any allocation of labor in
between these two positions could not result in a stable equilibrium because
an additional unit of labor would contribute more in output than the
previous unit of labor. A ranking of the desirability of these alternative
equilibria remained outside of standard comparative-static exercise of
showing the effect of protection on national income.
Second, although average cost analysis allowed a given intermediate allocation
of labor to be a stable equilibrium, an economic inefficiency was
also introduced. At any such equilibrium, average cost pricing implied that
wages would be set equal to the average product of labor, not its marginal
product as under perfect competition. In this case, too little labor would be
employed in manufacturing (where the marginal product of labor exceeds
the average product of labor) and output would be distorted from its optimum
level, introducing a potential corrective role for protection.
But Graham’s stunning contentions were swiftly challenged by Frank
Knight, later a leading economist at the University of Chicago. Knight’s
(1924) counterattack to Graham’s “fallacious” but “ingenious argument”
rested on the compatibility of increasing returns and competitive analysis.
Knight took issue with the following assumption that Graham (1923,
204n) had made in a footnote: “The reasoning in the text simply assumes
that a decreasing unit cost is obtained by an expansion of the production of
watches; whether the cause of it be external or internal economies is
immaterial to the theory, tho it would, of course, affect the degree of its
applicability.”
The distinction between internal and external economies, casually dismissed
by Graham, in fact proved critical to this debate. Internal and external
economies, both forms of increasing returns, were introduced into
economic analysis by Alfred Marshall in the late nineteenth century. Increasing
returns are internal to the firm when the production costs of a
particular firm decline as its own output expands. Increasing returns are
external to the firm when the production costs of a particular firm decline
as industry output expands, while its costs of production increase when its
CHAPTER NINE144
own output expands. As Marshall (1920, 220–21) put it, internal economies
(also known as economies of scale) are “dependent on the resources
of individual houses of business engaged in [the industry], on their organization
and the efficiency of their management.” External economies, by
contrast, are “dependent on the general development of the industry,” some
of which “depend on the aggregate volume of production of the kind in
the neighborhood while others again, especially those connected with the
growth of knowledge and the progress of the arts, depend chiefly on the
aggregate volume of production in the whole civilized world.”
Knight’s first point was that increasing returns internal to the firm are not
strictly compatible with competition in the industry.6
If a firm’s decline in
costs was a continuous function of its own output, then one firm could
serve the entire market at the lowest cost and the industry would become a
monopoly. As he (1924, 597) put it, “If competition is effective, the size of
the productive unit will tend to grow until either no further economies are
obtainable, or there is only one establishment left and the industry is a
monopoly. . . . When all establishments have been brought to the most
efficient size, variation in total output is a matter of changing their number,
in which no technical economies are involved.” Thus, Knight concluded,
an “increase in the output of a commodity must increase its cost of production
unless the industry is, or becomes, a monopoly.”
“The rejoinder to the above argument,” Knight continued, “is the doctrine
of ‘external economies.’” But this “surely rests upon a misconception,”
he added. “External economies in one business unit are internal
economies in some other, within the industry,” Knight argued, a point to be
discussed shortly. “Any branch or stage in the creation of a product which
offers continuously a chance for technical economies with increase in the
scale of operations,” Knight insisted, “must eventuate either in monopoly
or in leaving the tendency behind and establishing the normal relation of
increasing cost with increasing size.”
Knight also pointed out what proved to be a minor error in Graham’s
two-country example. He correctly noted that, in the example given above,
at least one of the countries would be completely specialized in one of the
commodities, bringing to a halt any change in the marginal productivities
of labor. If one country was still producing both goods, then the specialized
country would trade at an exchange ratio equal to the cost ratio of the diversified
country. In his reply, Graham (1925) conceded his mistake about the
exchange and cost ratio and specialization and went on to demonstrate that
it did not materially affect his results. But on Knight’s main contention,
Graham missed the point and essentially restated that the distinction between
internal and external increasing returns was unimportant.
6
This was recognized by Augustin Cournot in 1838 and by Alfred Marshall and others
later, but was apparently overlooked by Graham.
GRAHAM AND THE INCREASING RETURNS ARGUMENT 145
In his own reply, Knight (1925, 331–33) reiterated what Graham had
ignored: “What Professor Graham has to do to establish his theoretical
position is to show that . . . industry really operates under decreasing cost,
without tending toward monopoly.” Knight agreed that “if one can make
his assumptions in regard to decreasing cost, [Graham’s] conclusion is correct.”
However, “to vindicate decreasing costs in the sense required, it must
be shown that there are, or may be, industries, in a condition of stable
competition, in which no producer already engaged could decrease his real
costs by expanding his output at the expense of other producers, and yet in
which real costs would be decreased all around by new producers entering
the industry in competition with those already there.” But new entrants had
to bid factors of production away from other uses and perhaps had to employ
factors of lower quality: “These inevitable sources of increasing cost
must be more than offset by some kind of purely ‘external’ economies in
organization,” Knight argued. “In spite of the weight of authority which
may be cited for such economies, I have never succeeded in picturing them
in my mind, or finding any convincing reason to believe they exist; and the
hypothetical examples cited by Professor Graham in his reply has not assisted
me in doing so.” Even if he could, “I cannot believe such conditions
general enough to justify a special law in economic theory, or a special
provision in tariff legislation.”
Despite these and other criticisms, Graham never recanted his case for
protection. In a short book on tariffs published a decade later, Graham
(1934, 81) continued to maintain (in a chapter entitled “Rational Protection”)
that if a country did not specialize in an increasing returns industry
it “might steadily be losing opportunities to improve its per capita general
productivity and might even suffer an absolute decline therein.” For this
reason, “protection for comparatively incompetent industries of declining
cost per unit of output might then be warranted.” But by disputing the
compatibility of (internal) increasing returns and market competition,
Knight had undercut a big part of Graham’s case. As John Chipman (1965,
741) later wrote, “As long as Knight’s objection stood, Graham’s entire
argument—whatever other defects it had, and there were several—was vitiated
by having this as its premise.”
Taking their cue from Knight, other leading economists were equally
skeptical of Graham’s argument. Like Knight, Gottfried Haberler (1936,
198–208) granted that “Graham’s conclusion follows, provided that one
accepts his assumptions,” but he viewed those assumptions as “highly precarious.”
Jacob Viner accused Graham of making the same mistake Nicholson
had, that is, confounding marginal and average analysis. Viner (1937,
480) argued, “Had Graham dealt with his problem in terms of marginal
costs and marginal returns for both industries, he could not have obtained
results unfavorable to free trade.” This is because, Viner pointed out, and
Graham had partially acknowledged, “specialization in accordance with
CHAPTER NINE146
marginal cost to the industry of the country must be to the advantage of the
country, in so far as costs are made the criterion of advantage” (474).
Jan Tinbergen (1945, 182–99) picked up this issue and noted another
error in Graham’s analysis. Graham purported to show that the effect of
trade is to obtain a smaller number of watches for the same effort as originally
produced a larger number of watches via domestic production. But
Tinbergen pointed out that the larger number of watches was calculated on
the basis of the average (not the marginal) product of labor, whereas wheat
production was computed on the basis of the marginal product of labor
(which is lower than the average product). Graham had thus employed a
bogus measure of foregone output and, as Tinbergen illustrated geometrically,
if the correct marginal calculation had been made there was no loss
from trade.
But Knight’s strictures had far less force if one accepted the concept of
external economies. What precisely were these economies? As already
noted, Alfred Marshall described external economies simply as cost reductions
of an individual firm that are “dependent on the general development
of the industry,” that is, on the scale of industry output. The relevant industry
output could vary anywhere from local to national to world output; to
repeat Marshall’s words, “some depend on the aggregate volume of production
of the kind in the neighborhood while others again, especially
those connected with the growth of knowledge and the progress of the arts,
depend chiefly on the aggregate volume of production in the whole civilized
world.”7
F. Y. Edgeworth (1905) first succeeded in rendering the concept
of external economies compatible with competitive equilibrium,
something that could not be done with internal economies. Under external
economies, according to Edgeworth’s formulation, the marginal cost of an
individual firm was increasing in its own output, but its cost curve would
shift down with an increase in industry output. Because each firm was
small relative to the industry, industry output was taken as given and the
contribution of the firm’s own output to industry output was imperceptible.
In this way, each firm alone would operate under increasing costs, but the
industry supply curve might be downward sloped.8
7
For a discussion of Marshall’s ideas on increasing returns, see Renee Prendergast (1992).
8
An extensive debate during the 1920s and 1930s about the nature of these cost curves and
the relevance of external economies (and diseconomies) takes us too far from the field of trade
policy to merit review here. See the excellent discussion in John Chipman (1965, 736–49). In
the end, a consensus was apparently reached that accepted external economies as compatible
with competitive equilibrium. The social optimality of that competitive equilibrium, however,
was disputed. Believing that the market-determined output in such industries would be too
low, Alfred Marshall and A. C. Pigou argued that government subsidies were necessary to
raise industry output to the social optimum. Pigou later recanted this recommendation in the
case of internal economies after the attacks by Knight and Dennis Robertson, but did not
disavow subsidies in the case of external economies.
GRAHAM AND THE INCREASING RETURNS ARGUMENT 147
As Knight’s skeptical remarks indicated, the entire concept of external
economies was never uncritically accepted, let alone its policy implications,
partly because of Marshall’s (and his followers’) vague formulation
of the idea. Dennis Robertson (1924, 24) expressed the confusion this way:
an external economy really “only means that, given time and the progress
of organisation, a larger output can be produced at a lower cost per unit
than a smaller output used to be.” But, he added, “we used not to dare
conceive of falling cost per unit as a determinant of increased output, but
only as resulting from it, or at the rashest as ‘being associated with it.’”
Robertson also noted that by mixing a discussion of static external economies
with that of the dynamic elements of industry evolution and technological
progress, Marshall’s treatment was an invitation for further confusion.
He questioned whether a subsidy or tariff was necessary to promote
the development of external economies, inquiring, “is not the body
(whether a private monopolist or State) which seeks to improve substantially
on competitive output in such cases [of ‘decreasing cost’] seeking to
voyage pennis non homini datis, and not merely to penetrate the secrets of
Time, but to do that leisurely old gentleman’s work for him?”
The policy implications, of course, hinged specifically on what one had
in mind as generating the external economies. As early as the 1870s,
Marshall described three types of external economies: knowledge spillovers
between firms, subsidiary supplier industries, and local pools of
skilled labor. Knowledge spillovers, in which firms are thought not to appropriate
fully the benefits of their investments in knowledge-generating
activities, result in an unpaid side effect of one firm’s activity on others and
possibly the underprovision of that activity relative to the social optimum.9
Pigou interpreted this as an externality in which the marginal social benefit
of knowledge production exceeds the marginal private benefit of this activity,
calling for, in principle, a government subsidy to close this divergence
(and thereby increase national income). However, knowledge spillovers
are not necessarily related to static external economies because they need
not be linked to the scale of current output.
The last two examples, by contrast, are more consistent with what are
viewed today as external economies: namely, market-size effects, wherein
9
Marshall (1920, 225) described knowledge spillovers this way: “Inventions and improvements
in machinery, in processes and the general organization of the business have their
merits promptly discussed: if one man starts a new idea, it is taken up by others and combined
with suggestions of their own; and thus it becomes a source of further new ideas.” He also
implied that distance was becoming less important a factor in localizing knowledge. “For
External economies are constantly growing in importance relative to Internal economies in all
matters of Trade-knowledge: newspapers, and trade and technical publications of all kinds are
perpetually scouting for him and bringing him much of the knowledge he wants—knowledge
which a little while ago would have been beyond the reach of anyone who could not afford to
have well-paid agents in many distance places” (237).
CHAPTER NINE148
the larger the size of the market, the greater the productivity of the firms in
the industry. For example, a large industry is better able to support more
specialized suppliers of producer services, which in turn reduce the industry’s
costs and increase industry output. Marshall and his followers construed
these to be external economies in the following sense: if a firm decides
to enter an industry or increase its output, that firm does not take into
account the fact that this entry and additional output will lower the cost of
production for all other firms in the industry.
Yet Marshall’s (1920, 264) description of this phenomena was characteristically
vague: “The most important of these [external economies] result
from the growth of correlated branches of industry which mutually
assist one another, perhaps being concentrated in the same localities, but
anyhow availing themselves of the modern facilities for communication
offered by steam transport, by the telegraph and by the printing-press.”
Unfortunately, Marshall’s followers were no more successful in coming up
with compelling instances of such economies. Thus, it was never entirely
clear whether such “obvious” instances of such economies (“transport developments,
the telephone and the trade journal, the shop of the club and
the market price, subsidiary industries, a skilled labour supply,—we have
all at some time tried to memorise and to reproduce the formidable list,”
Robertson [1924, 26] remarked) were just descriptions of market interdependencies
and evolution rather than true examples of market failures
requiring some form of government action.
In some cases, such as transport developments, Knight’s statement that
external economies in one industry were internal economies to another
rang true. In other cases, the external economy could be internalized
through market mechanisms such as vertical integration or other pricing
arrangements. But the whole concept of external economies still remained
elusive. As E.A.G. Robinson (1931, 138) seemed to lament: “And so we
chase this will-o’-the-wisp of external economy through industry after industry,
and we find it vanishing in the end or absorbed in the economies of
firms or organisations below their optimum capacity.” And Robertson’s
quip, that policy action to exploit external economies would have the state
merely trying to accelerate what time and progress of organization would
naturally bring about, hardly made the case more compelling.
The elusive nature of external economies ensured that suspicions about
the concept were never completely dispelled. Even more slippery were the
implications for government policy, let alone free trade. Depending on
one’s interpretation, external economies could be so rare as to be essentially
a curiosa, or could reflect a pervasive interdependence that is rife
through every sector of the economy. This greatly confused the issue in
terms of its ramifications for free trade. A particular external economy
might indeed call for a government subsidy to encourage the underpro-
GRAHAM AND THE INCREASING RETURNS ARGUMENT 149
vided activity, and international trade might reinforce an undesirable direction
of specialization. But the implications for commercial policy were still
not obvious. Haberler (1936, 207), for instance, complained that external
economies were so “vague and indeterminate in nature” and so “difficult to
estimate [as to] their extent or value” that “it is not really practicable to base
a policy of Protection” on their possible existence. The standard examples
of external economies given in the 1920s and 1930s were described years
later by Chipman (1965, 746) as being “so far-fetched that it is difficult to
understand how an entire theory of commercial policy can be based upon
them.”
Yet even if one accepted uncritically the possible existence of external
economies, Graham’s case did not go unchallenged. Another critic pointed
to the importance of reversibility of costs. Graham’s position was that protection
had to be permanent because, if protection were to be removed, the
increasing returns sector (being one of comparative disadvantage) would
contract and costs would begin to rise again. Unlike the dynamic infant
industry argument, in which the cost reductions are irreversible once the
infant has grown up and protection has been removed, Graham’s case is
static and therefore a permanent policy action is required to hold the economy
in a particular equilibrium. Karl Anderson (1936, 167) believed that
Graham’s argument was weakened if “the sources of decreasing costs
when once discovered and utilized are not to be lost again.” Stating flatly
that “nonreversibility is clearly the case with genuine external economies”
because their presumed source, once in place, was not likely to be dislodged,
Anderson concluded that “the basis for the kind of protection defended
by Graham is all but completely destroyed.” Yet this conclusion is
simply an assertion; durability remains a debatable issue. Even if it were
true, he neglected to mention that Graham’s case then essentially reverts to
the dynamic infant industry case.
But it was Viner (1937, 475–82) who delivered the key qualifications to
the use of trade policies to take advantage of external economies. First,
the implications for trade policy depended critically upon whether the
external economies were a function of world output or domestic output.
If the economies depended upon the size of the world market, then domestic
firms would not be especially handicapped if some domestic firms reduced
their output. For example, if the size of the world watch industry
was affected by some special attributes of the world watch machinery industry,
and such machinery were freely traded, there was no particular
problem for domestic firms.10
If part of the domestic watch machinery industry
contracts, all watch firms in the world are affected symmetrically by
10
In Viner’s (1937, 480) words, “If there is free trade in machinery, this economy in machinery
costs will not be lost to the watch industry in a particular country merely because it is
shrinking in size, if there is no shrinkage in the size of the watch industry as a whole.”
CHAPTER NINE150
the lost economies, not just domestic ones specifically. This weakens the
potential case for promoting domestic firms and directs attention to the
tradeability of intermediate goods, a key point in modern treatments of
external economies.
Second, Viner (1937, 480) took the position that, if the external economies
were pecuniary, “then they are not real national economies and nothing
is lost to the country when they disappear.” To clarify this comment,
Viner’s (1931) distinction between “technological” and “pecuniary” external
economies needs to be understood. Technological external economies
described the interdependence of firms in a particular market in which
the production function of individual firms was affected directly by the
output of the industry as a whole; pecuniary external economies were those
in which the profits of a firm were directly affected by the activities of other
(upstream or downstream) producers. Tibor Scitovsky (1954, 145) later
clarified these concepts and drew the implication that “technological external
economies are the only external economies that can arise because of
direct interdependence among producers and within the framework of general
equilibrium theory.” However, Scitovsky spoke of the “scarcity of
technological external economies” because “it is not easy to find examples
from industry” of them. It is difficult to consider changes in the organization
of production as technical externalities, for example.11
Viner (1937, 480–81) concluded in this way:
A conceivable case for protection on the basis of the existence of external
economies in an industry which from the individual producer’s point of view
is at a comparative disadvantage in costs can be made out, therefore, only
where these external economies are (a) dependent on the size of the national
and not the world industry and (b) are technological rather than pecuniary, or,
if pecuniary, are not at the expense of domestic sellers or services or materials
to the industry. The scope for the application of the argument is extremely
limited, especially as it seems difficult even to suggest plausible hypothetical
cases of the existence of genuine technological external economies.
This reduced Graham’s example to, in his words, “little more than a theoretical
curiosity.”
The decades after Alfred Marshall’s first exposition on external economies
revealed that economists did not really understand how to think
clearly about such effects, let alone draw out the implications for trade
policy. At the same time it did not seem worthwhile to abandon the concept
entirely because it appeared keenly relevant to the seemingly arbitrary na-
11
According to Scitovsky (1954, 136), “pecuniary external economies clearly have no
place in equilibrium theory” because such “all-pervading” interdependence through the market
mechanism cannot be held to lead both to an optimal allocation of resources and to a
failure to lead to that optimum.
GRAHAM AND THE INCREASING RETURNS ARGUMENT 151
ture of comparative advantage in certain instances. An oft used example
from R.C.O. Matthews (1949–50) asks, why is it that Germany specializes
in cameras and Switzerland in watches? What is the role played by initial
advantages in the past that cumulate to the present? Do scale economies or
external economies account for this concentration and localization? If so,
could not the location of the two industries be reversed and does this not
illustrate the potential (as discussed earlier) for multiple equilibria?
Although the debate over external economies and comparative advantage
was never satisfactorily resolved in the immediate aftermath of
Graham’s article, the study of the trade-related aspects of external economies
nearly evaporated until the early 1980s. By this time, analysis suggested
that Graham’s case, taken on his own assumptions about external
economies, was largely correct. Arvind Panagariya (1981) described a
small open economy with a decreasing returns and an increasing returns
industry (via constant-returns-to-scale firms with economies external to the
firm but internal to the industry, thereby consistent with perfect competition
and average cost pricing). Under these assumptions, a permanent subsidy
to expand output in the increasing returns industry (or conversely a tax
to discourage output in the decreasing returns industry) is required to maximize
national income. A country completely specialized in the decreasing
returns industry may suffer a welfare loss after the opening to trade, although
that depended upon whether the terms of trade moved in a favorable
enough direction. As in the infant industry case, the optimal policy is an
appropriately chosen subsidy and not a tariff which engenders the additional
distortion to consumption choices. Related work by Wilfred Ethier
(1982b) pointed out the implicit importance of country size in Graham’s
argument; the country specializing in the decreasing returns sector was less
likely to lose by trade the smaller the country is and (paradoxically) the
greater the degree of increasing returns.
But this work, and others like it, just assumed the existence of external
economies. In the absence of more concrete evidence about such economies,
or whether they arose inherently from a certain, plausible market
structure, the practical importance of external economies for free trade remained
open to question. Ethier (1982a) later provided a possible theoretical
foundation for external economies in which each firm operates
under constant returns to scale but the industry overall exhibits increasing
returns. The example drew upon Marshall’s suggestion that a larger
industry can support a greater variety of specialized inputs to production at
lower cost. Ethier showed the following: if there are economies of scale
within each firm that produces a differentiated intermediate good (that is,
monopolistic competition), then the aggregate production function of the
industry that assembles these components exhibits the features of external
economies.
CHAPTER NINE152
The key issue again revolves around Viner’s point about whether the
intermediates are tradeable or not. If the intermediate goods are tradeable,
then the external economy depends on international production of the final
good, not domestic production, and there is no strong case for government
action. If the intermediates are nontradeable, then the external economy is
strictly national in scope and depends on the extent of domestic production.
In the latter case, the size of the domestic market can determine comparative
advantage; a larger market will support larger industries and hence
have lower costs than those in smaller markets. Under this Ethier specification,
as James Markusen (1990) has pointed out, external scale economies
lead to several potential distortions, including multiple equilibria (with a
high and a low level of output of the industry with external economies),
average cost pricing, and inefficient factor combinations. A one-time production
subsidy could be used to establish the right equilibria, and then a
permanent factor subsidy could be used to correct for the inefficient factor
combination. But the desirability of Graham’s permanent protection is not
so obvious.
⅐ ⅐ ⅐
Increasing returns in the form of external economies of scale still prove to
be somewhat vexing: their effects seem potentially important and difficult
to dismiss, yet our ignorance about them is still vast after a century of
debate. With small differences in initial market size, trade could potentially
reinforce a certain pattern of international specialization. But until the
underlying factors giving rise to external economies are better understood,
the case for a trade remedy of import protection as the obvious, first-best
policy response has not been made. Our understanding of the determinants
and effects of external economies is so weak, both conceptually and practically,
that it has yet to be established whether they offer a reasonably clear
case in which protection could enhance economic wealth. A greater division
of labor may come about as a result of extending the market, but extending
the market by artificial means does not necessarily generate a
greater division of labor that results in scale advantages.